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Planning
Today for Today's LifeStyle.
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For many Americans, a significant portion of their estate value is
in Qualified Retirement Plans (QRPs). This remains true despite the
(inevitable) ups and downs of the stock market after decades of an un-precedented
bull 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withdrawn.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 they grow through the miracle of compound
interest without the barnacles of annual income taxation.
In this article we consider some unique tax and
non-tax challenges facing married couples when selecting the Designated
Beneficiary (DB) of their QRPs. First, however, an overview of some death
tax fundamentals would be helpful.
Basics
Your estate value includes everything that
you own, to include your QRP, your life insurance death benefits, your
real estate, your overall non-qualified investment portfolio and your
collectibles.
Under current tax law, every taxpayer has a $1
million Applicable Exemption Amount to protect their estate from federal
estate taxes that boast progressive tax rates up to 50%. Accordingly, a
married couple may protect a total of $2 million through proper Life &
Estate Planning.
This is not automatic, however. Without proper
planning, a married couple may lose the full benefit of their combined $2
million protection…and unnecessarily enrich 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
$2 million. Wife has a $1 million QRP and selects Husband as the DB. When
Wife dies, Husband inherits the QRP as an income tax free 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.]
No federal estate taxes are due upon Wife’s
death because of the Unlimited Marital Deduction. [Note: Since the
Economic Recovery Tax Act of 1981, all lifetime gifts and post-mortem
transfers between spouses are non-taxable.] But this Unlimited Marital
Deduction itself can be a very expensive tax trap.
Any assets passing to a surviving spouse via the
Unlimited Marital Deduction forfeit the federal estate tax savings
otherwise available under the Applicable Exemption Amount of the deceased
spouse. In our example, Husband now has the full $2 million in his estate.
Assuming Husband’s Applicable Exemption Amount is less than the estate
value at the time of his death, this couple will incur an unnecessary
federal estate tax liability. A Disclaimer CST is a practical alternative
this couple should consider to avoid this tax trap.
Disclaimer
CST
Given the same basic facts as above, Wife
could create a Credit Shelter Trust (CST) as part of her Life & Estate
Plan. As its name implies, this CST could shelter her QRP from federal
estate taxes by using (and not forfeiting) her available Applicable
Exemption Amount.
Under this approach, Wife would select Husband as
the Primary DB of her QRP and her CST as the Contingent DB. Upon Wife’s
death, Husband could disclaim the QRP and the CST would become the DB by
default. Result: Wife’s Applicable Exemption Amount would be applied to
the value of her QRP disclaimed to the CST, yet Husband would be the
beneficiary under the CST. Downside: Since the CST is not a surviving
spouse, no rollover of Wife’s QRP is permitted and income taxable
distributions must begin to Husband regardless of his Required Beginning
Date.
While this technique may forfeit the income tax
deferral available through the spousal rollover, it may achieve
significant federal estate tax savings. Nevertheless, the CST 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.
Blended
Families
Fact: There are more blended families in
the United States today than original nuclear families. If yours is a
blended family, then you should give careful consideration to your choice
of Primary and Contingent DBs. Otherwise, you may unintentionally
disinherit some of your loved ones.
Again, assume the same basic facts as above,
except Husband and Wife have adult children from their respective prior
marriages and a minor child from their marriage together.
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Dilemma #1:
If Wife identifies Husband as
the Primary DB of her QRP and her CST as the Contingent DB, then what will
Wife’s own children inherit from her upon Husband’s subsequent death
assuming: (a) Husband did not disclaim the QRP to Wife’s CST under which
Husband and then Wife’s children are the beneficiaries; or (b) Husband
failed to specifically identify Wife’s children as among the Primary DBs
under his rollover of Wife’s QRP? Answer: Nothing.
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Dilemma #2:
Can Wife identify her CST as
the Primary DB of her QRP instead of Husband without his knowledge?
Answer: No. With very limited exceptions, under federal law a surviving
spouse has special rights to the QRP of their 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.
We will call it the QRP insured triple play.
Triple
Play
There are few more exciting defensive
plays in the game of baseball than the triple play. It is where
preparation and opportunity meet with no margin for error. So it is with
the QRP insured triple play. Here is how it works, assuming the same facts
as above.
First, Wife identifies Husband as the Primary DB
of her QRP, with her CST as the Contingent DB. Wife’s CST identifies
Husband, along with their yours, mine and ours children as beneficiaries.
Upon Wife’s death, Husband can either: (a) elect the QRP rollover for
the income tax savings, instead of the potential federal estate tax
savings attained through a disclaimer to Wife’s CST; or (b) elect to
disclaim the QRP to Wife’s CST for the potential federal estate tax
savings, instead of the income tax savings of a QRP rollover. If Husband
elects (a), then he must arrange his Primary DB carefully to include
Wife’s children or they will be disinherited. However, 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 $1 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 $1
million policy, not a dime is included in their estate value for federal
estate tax purposes.
Third, upon Wife’s death, she is assured that
her children will inherit $1 million from her through the ILIT…even if
Husband elects the QRP rollover and fails to include her children among
his Primary DBs.
In baseball, a perfectly executed triple play may
not guarantee victory, but it can help you survive a very difficult
inning. Similarly, a perfectly executed QRP insured triple play may not
guarantee both income and estate tax savings. It can, however, help you
provide for all of your loved ones and preserve your family harmony.
Conclusion
This has been a brief introduction to an
extremely complex topic. There are many tax and non-tax traps awaiting the
unwary when it comes to your QRP. Always seek qualified legal counsel for
assistance.
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