Disclaimer Dilemma
Qualified Retirement Plans (QRPs) comprise a significant share of
the estate value for many Americans. This remains true despite the
inevitable ups and downs of the stock market. One reason QRPs weather
economic storms better than non-qualified investments is their unique
tax treatment.
All contributions to QRPs are made with pre-tax
dollars and all of the growth inside such plans is tax-deferred
until withdrawn. Hence, contributions to QRPs not only reduce your
current income tax liability, but also grow with compound interest and
without the reductions for annual income taxation.
However, married couples in particular face
unique tax challenges when selecting the Designated Beneficiary (DB)
of their QRPs.
Death Tax Basics
Contrary to popular belief, QRP assets are included in the overall
value of your estate for estate tax purposes. Under current tax law,
every taxpayer has a $2 million Applicable Exemption Amount,
which can be used to exempt assets from estate taxation. (This is an
extremely valuable exemption because estate tax rates are progressive,
and can exceed 45 percent.) Accordingly, a married couple may, with
proper estate tax planning, use two of these exemptions to protect a
total of $4 million in estate value.
This double exemption, however, is not
automatically applied and, without proper planning, a married couple may
lose the full benefit of their combined $4 million protection to the
unnecessary enrichment of the IRS.
Tax Trap
How do married couples fail to maximize
their federal estate tax protection? Consider the following case study.
Husband and Wife have a combined estate value
of $4 million. Wife has a $2 million QRP and Husband has $2 million in
non-QRP assets. Wife selects Husband as the designated beneficiary of
her QRP. When Wife dies, Husband inherits the QRP as an
income-tax-deferred rollover. [Note: Only a surviving spouse may
rollover an inherited QRP and continue to defer withdrawals until such
spouse's own Required Beginning Date of April 1st of the calendar
year after turning age 701/2.]
Because of the Unlimited Marital Deduction there
are no federal estate taxes due. But, this can be a tax trap. Any assets
passing to a surviving spouse via the Unlimited Marital Deduction forfeit
the Applicable Exemption Amount of the deceased spouse. Think of
it as an unused, expired coupon. In our example, Husband now has
the full $4 million in his estate. He can use only his own Applicable
Exemption Amount "coupon," as his deceased wife's is no longer
available. This may result in an avoidable federal estate (and income)
tax liability.
Disclaimer CST
Given the same basic facts as above, Wife
could create a Credit Shelter Trust (CST).
Under this approach, Wife would select Husband
as the Primary Designated Beneficiary of her QRP and name the
trust as Contingent.
Upon Wife's death, Husband could disclaim
the QRP, making the Credit Shelter Trust the designated beneficiary by
default.
Result: Wife's Applicable Exemption Amount
would be applied to the value of her QRP (which Husband disclaimed to
the trust). Husband can still have access to the QRP assets, however, as
the trust beneficiary. The downside is that because the trust is not a surviving
spouse, no rollover of Wife's QRP is permitted and income-taxable
distributions must begin to Husband.
While this technique may forfeit the income tax
deferral available through the spousal rollover, it may achieve
significant federal estate tax savings. Nevertheless, the Credit
Shelter Trust Disclaimer alternative allows the surviving spouse to
retain maximum flexibility over the couple's combined wealth and its
ultimate disposition. Therefore, it is most appropriate in first
marriages where any children are those of that marriage. Blended
family situations, on the other hand, present unique planning
challenges.
Insuring Legacies
Did you know that you may unintentionally disinherit your children from
your Qualified Retirement Plans (QRPs), especially if yours is a
blended family?
To illustrate this point, assume the following
facts:
- Husband and Wife have adult children from their respective prior
marriages and a minor child together.
- Wife has a $2 million QRP.
- Wife selects Husband as the Designated Beneficiary (DB) of her QRP.
- Wife establishes a Credit Shelter Trust (CST) with Husband and
then children as beneficiaries.
- Wife also names the CST as the Contingent Beneficiary of her QRP.
- When Wife dies, Husband inherits the QRP as an income-tax-deferred
rollover.
Dilemma #1: What will Wife's own
children inherit from her upon Husband's subsequent death if:
(a) Husband does not disclaim the QRP to
Wife's CST; or
(b) Husband fails to specifically identify
Wife's children as among the Primary DBs after rolling over Wife's QRP
to his own name?
Answer: Nothing.
Dilemma #2: Can Wife identify her CST as
the Primary DB of her QRP instead of Husband without his knowledge?
Answer: Generally no. With very limited
exceptions, under federal law a surviving spouse has special rights to a
(non-IRA version) QRP of the deceased spouse.
Is there any alternative that would allow
Husband to rollover the QRP, while ensuring that Wife's children are not
totally disinherited?
Answer: Yes, by insuring their legacies through
a funded Irrevocable Life Insurance Trust (ILIT).
The ILIT
Here is how an ILIT funded with a proper
amount of life insurance would benefit the blended family in our case
study.
First, Wife identifies Husband as the Primary
Designated Beneficiary of her QRP, with her CST as the Contingent.
Wife's CST identifies Husband as the primary beneficiary, with all
their children as the remainder beneficiaries. Upon Wife's death,
Husband can either: (a) elect the QRP rollover for the income tax
savings; or (b) elect to disclaim the QRP, sending it to Wife's
CST.
If Husband elects (a), then he must arrange his
Primary Designated Beneficiaries to include Wife's children or they will
be disinherited. If he elects (b), then neither he nor any of the
couple's children will be disinherited.
Second, Wife creates an Irrevocable Life
Insurance Trust (ILIT) that in turn applies for and owns a $2
million life insurance policy on her life. The ILIT is named as
beneficiary under the policy, with Wife's children as the beneficiaries
of the ILIT. Because neither Wife nor Husband is the applicant, owner or
beneficiary of the $2 million policy, the proceeds are not included in
their estate value for federal estate tax purposes.
Third, upon Wife's death, she is assured that
her children will inherit $2 million from her through the ILIT … even
if Husband elects the QRP rollover and fails to include her children
among his Primary DBs.
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