|
|
Retirement
Roulette
 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withdrawn.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.
- 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.
-
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.
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.
|
