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All contributions to QRPs are made with pre-tax dollars and all of the growth inside such plans is tax-deferred until withdrawn.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 70˝. 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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