Disclaimer
Dilemma
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. 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withdrawn.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 may be helpful.
Death
Tax Basics
Your estate
value includes everything that you own, to include your QRP. Under
current tax law, every taxpayer has a $1.5 million Applicable
Exemption Amount to protect their estate from federal estate taxes
that boast progressive tax rates exceeding 45%. Accordingly, a married
couple may protect a total of $3 million through proper estate tax
planning. This is not automatic, however. Without such planning, a
married couple may lose the full benefit of their combined $3 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 $3 million. Wife has a $1.5 million QRP and Husband has $1.5 million
in non-QRP assets. Wife selects Husband as the DB 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 70½. See the Uniform
Lifetime Table.]
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.] Nevertheless,
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 $3 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 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.
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
If yours is a blended family, then you should
carefully evaluate your options regarding your choice of Primary and
Contingent DBs. Otherwise, you may unintentionally disinherit some of
your loved ones. For more about QRP planning for blended families, see
our article, Insuring Legacies.
Insuring
Legacies
As noted in Disclaimer Dilemma, one may unintentionally
disinherit their loved ones
from their Qualified Retirement Plans (QRPs), especially in the
context of a blended family.
To illustrate this point, assume the same facts from the case study in
the Disclaimer Dilemma, except that Husband and Wife have adult
children from their respective prior marriages and a minor child from
their marriage together.
Dilemma #1: If Wife identifies Husband
as the Primary Designated Beneficiary (DB) of her QRP and her Credit
Shelter Trust (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 after his rollover of Wife's QRP? Answer: Nothing.
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, by insuring their legacies through a funded Irrevocable Life
Insurance Trust (ILIT). Here is how an ILIT funded with a proper
amount of life insurance would benefit the blended family in our case
study.
The
ILIT
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 $1.5
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 $1.5 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 $1.5 million from her through the ILIT…even if Husband elects
the QRP rollover and fails to include her children among his Primary DBs.
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.
Copyright © 2005 Integrity Marketing Solutions. All rights
reserved. Some artwork provided under license agreement. This
publication does not constitute legal, accounting or other professional
advice. Although it is intended to be accurate, neither the publisher
nor any other party assumes liability for loss or damage due to reliance
on this material.
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