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  All contributions to QRPs are made with pre-tax dollars and all of the growth inside such plans is tax-deferred until withdrawn.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 70^1/2.]
     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:

1. Husband and Wife have adult children from their respective prior marriages and a minor child together.
2. Wife has a $2 million QRP.
3. Wife selects Husband as the Designated Beneficiary (DB) of her QRP.
4. Wife establishes a Credit Shelter Trust (CST) with Husband and then children as beneficiaries.
5. Wife also names the CST as the Contingent Beneficiary of her QRP.
6. 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.