Creative Uses of Trusts and Asset Protection Strategies

Creative Uses of Trusts & Asset Protection Strategies

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Estate Planning for Second Marriage

by Natalie Choate | 05-13-11

Question: My client, who has a significant 401(k) plan through his small business, is getting remarried at age 64. Following the marriage, his estate planning goal is to have his new spouse (now age 58) be named as life beneficiary of his plan benefits, entitled to receive only the minimum required distribution, with any balance remaining at the spouse's later death to pass to the client's children (currently ages 40 and 35). He wants the benefits to qualify for the marital deduction for estate tax purposes, but does not want the wife to be able to access a lump sum distribution or change the successor beneficiaries. Further complicating this, when my client dies, the business will come to an end and have to be liquidated, which involves terminating the plan. Another problem is how we can get the future wife to accept this estate plan prior to the marriage.

Answer: The plan this client wants poses a number of legal hurdles and income tax disadvantages.

Perhaps there is a need to step back from these complications and look for a better way to

accomplish his goals. The plan he has in mind would require naming a trust as beneficiary of the retirement plan. The trust would provide that the wife would receive, each year, the income of the trust's non-retirement assets (if any), plus the "greater of" the minimum required distribution from the retirement plan for that year or the "income" of the plan for such year. Upon her death, the balance of the retirement benefits

(if any are left) would pass to the client's children. This type of trust is called a "QTIP trust" (for "qualified terminable interest property"), a name derived from the Internal Revenue Code section dealing with marital deduction trusts. If the trustee withdraws from the plan in any year more than the income/minimum distribution amount, the excess would be held in the trust for later distribution to the children. While that sounds fairly straightforward, this proposed plan would have to clear numerous hurdles.

After he and his family pay hefty legal fees to prepare and implement this plan, the client might then look down from heaven some years hence to see that his children receive exactly nothing from his retirement plans and his wife received much less than she could have received if things had been done a little differently.

Here are the obstacles to success with the QTIP trust plan; a suggested alternative approach at the end of this outline avoids these problems.

Federal spousal rights. Under federal law, once he and his new wife have been married for one year, he cannot designate anyone other than his surviving spouse as beneficiary of this plan unless she consents to allow him to name someone else. So, after the one-year period, he cannot leave his 401(k) plan to a QTIP trust without his spouse's consent. (Many retirement plans don't bother with the one-year waiting period; they give the spouse this consent right immediately upon the marriage.)

This right cannot be waived in a prenuptial agreement, according to the Department of Labor. Having the spouse agree, in a prenuptial agreement, that she will later waive these benefits might work, especially if she is given a significant financial incentive to consent, but that outcome is not guaranteed.

See-through trust rules. A QTIP trust named as beneficiary of the plan would need to qualify as a "see-through trust" under the IRS' "minimum distribution trust rules" in order for the trust to obtain a "stretch" payout of the benefits over the life expectancy of the oldest trust beneficiary (the wife). If the trust does not so qualify, then the benefits will have to be distributed out of the plan or IRA and into the trust within five years after the participant's death. Thus, the trust would need to be drafted by an estate planning lawyer familiar with the tricky see-through trust rules.

Wife must receive greater of minimum distribution or income. If the trust provides that the wife will receive only the minimum required distribution, it will not qualify for the federal estate tax marital deduction. To qualify for the marital deduction, the trust needs to provide that the wife will receive, each year, at least the income of the retirement plan (which could be more or less than the minimum required distribution in any particular year), as well as the income of any other trust assets. Again, we are faced with the need for an estate planning attorney who is experienced in drafting trusts for retirement benefits.

Benefits must be rolled to an IRA after the client's death. Because the 401(k) plan will

terminate at the client's death, the benefits will need to be either cashed out in a lump sum or "direct rolled" into an inherited IRA when he dies. A rollover to an inherited IRA is the only way to preserve the option of a "stretch" (life expectancy) payout at that point. That option will be available if the plan beneficiary is either the surviving spouse, the children, or a see-through trust. This option is not available if, for some reason, the trust that is named as beneficiary "flunks" the IRS' minimum distribution trust rules. There is nothing wrong with post-death beneficiary direct rollovers, but the client should be aware that this is an additional complication of his plan--one that would not arise if he rolled the benefits to an IRA prior to his death.

Booby prize: Nothing left for the children. What do you get for successfully meeting all of those challenges? If the benefits are left to a QTIP trust as contemplated by the client's proposed plan, and the wife lives to her late-80s or later, there will be nothing left for the children at the wife's death--even if the trust qualifies as a see-through trust, and even if the wife has consented to allow the trust to be named as beneficiary! That's because the client has specified that the entire minimum distribution is to be distributed to the wife each year. Minimum distributions will be based on the wife's life expectancy. Under the IRS tables, the wife's life expectancy would run out when she reaches approximately age 85. At that point the entire plan would have been distributed (and taxed) to the wife, so there would be nothing left for the children. To counteract that effect, the trust would have to provide that the wife does not receive the entire required minimum distribution; she just receives the "income" of the trust (as required by marital deduction rules). But in that case, the amount held back and retained in the trust for future distribution to the children will be taxed at trust income tax rates. A trust goes into the highest bracket (currently 35%, scheduled to rise starting in 2013) at a mere $11,800 or so of taxable income. So accumulating retirement plan distributions inside a QTIP trust for future distribution to the children comes at a very high price.

Plan sacrifices major deferral potential: By leaving benefits to a QTIP trust, the client is throwing away all of the potential deferral benefits of the spousal rollover as well as of a life expectancy payout based on his children's young ages. Thus, the plan is not only complicated in terms of its legal structure and requirements, it is very beneficial to the IRS. The client may want to consider another approach. Because of the spousal consent rule, the client is not free to leave the benefits either to his children or to a QTIP trust--the wife is the mandatory sole beneficiary (at least she will be after they are married for a year), and a prenuptial agreement waiving that right could be problematic. The client can remove this "blackmail" factor by rolling the benefits to an IRA prior to the marriage. Then the couple can agree upon a fair estate plan and disposition of the benefits via a prenuptial agreement that is clearly enforceable. (The federal spousal consent rules do not apply to IRAs.) Even if the husband continues to have future accruals under the 401(k) plan, and these become subject to spousal consent, the main bulk of the retirement plan money will have been rolled to the IRA and thus will have a "secure future."

Then, instead of leaving the benefits to a QTIP trust, the client should consider purchasing (through a trust) enough life insurance to provide everything for his wife that he wants to provide for her, while naming his children as beneficiaries of the IRA. The insurance trust would be structured to be outside the client's estate. The wife would receive the trust's income for life plus principal in an amount specified by the client (such as for health and support, or equal to a minimum dollar amount or percentage each year).

If the benefits are left outright to the children, the distributions can be spread over the children's long life expectancy. That's not possible with a QTIP trust, because the wife is the oldest beneficiary. The distributions can be taxed at the children's tax rate (normally lower than the tax rate applicable to a trust; humans don't get into the highest tax bracket until they have more than $370,000 of taxable income).

This plan costs more in terms of insurance premiums. The tax savings after the client's death should outweigh the premium cost during his life--and his children will get something from their father instead of nothing!

The views expressed in this article are the author's.

Four Tips for Tax Smart Investing

At times, you may use losses in your investment portfolio to help offset realized gains.

Savvy investors have long realized that what their investments earn after taxes is what really counts. After factoring in federal income and capital gains taxes, the alternative minimum tax (AMT), and potential state and local taxes, your investment returns in any given year may be reduced by 40% or more. Luckily, there are tools and tactics to help you manage taxes and your investments. Here are four tips to help you become a more tax-savvy investor.

Tip #1: Invest in Tax-Deferred and Tax-Free Accounts

Tax-deferred investments include company-sponsored retirement savings accounts such as traditional 401(k) and 403(b) plans and traditional individual retirement accounts (IRAs). In some cases, contributions to these accounts may be made on a pre-tax basis or may be tax deductible. More important, investment earnings compound tax-deferred until withdrawal, typically in retirement, when you may be in a lower tax bracket.

Contributions to Roth IRAs and Roth 401(k) savings plans are not deductible. Earnings that accumulate in Roth accounts can be withdrawn tax free if you are over age 59 1/2, have held the account for at least five years, and meet the requirements for a qualified distribution.

Tip #2: Manage Investments for Tax Efficiency

Tax-managed investment accounts are managed in ways that can help reduce their taxable distributions. Your investment professional can employ a combination of tactics, such as minimizing portfolio turnover, investing in stocks that do not pay dividends, and selectively selling stocks that have become less attractive at a loss to counterbalance taxable gains elsewhere in the portfolio. In years when returns on the broader market are flat or negative, investors tend to become more aware of capital gains generated by portfolio turnover, since the resulting tax liability can offset any gain or exacerbate a negative return on the investment.

Tip #3: Put Losses to Work

At times, you may be able to use losses in your investment portfolio to help offset realized gains. It's a good idea to evaluate your holdings periodically to assess whether an investment still offers the long-term potential you anticipated when you purchased it. Your realized losses in a given tax year must first be used to offset realized capital gains. If you have "leftover" losses, you can offset up to $3,000 against ordinary income. Any remainder can be carried forward to offset gains or income in future years.

Tip #4: Keep Good Records

Keep records of purchases, sales, distributions, and dividend reinvestments so that you can properly calculate the basis of shares you own and choose the most preferential tax treatment for shares you sell.

Keeping an eye on how taxes can affect your investments is one of the easiest ways to help enhance your returns over time. For more information about the tax aspects of investing, consult your tax professional.

The information in this article is not intended to be tax advice and should not be treated as such. You should consult with your tax advisor to discuss your personal situation before making any decisions.

© 2011 McGraw-Hill Financial Communications. All rights reserved.

March 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by James P Ellman ChFC and Barry Mendelson CFP local members of the FPA.