From the July 2007 issue of Boomer Market Advisor • Subscribe!

Split the IRA, spare the family

Last month, I wrote about IRA beneficiary designations for the traditional family, where neither the husband nor the wife remarried as a consequence of death or divorce. When children are involved, estate planning for the traditional family is fairly straightforward.

But a second marriage introduces complications that need to be handled with more finesse. How can you help your client (in this case a dad who has remarried) provide for his second spouse as well as his children from his first marriage?

Most attorneys advise a Qualified Terminable Interest Property Trust (QTIP), which provides the second spouse with an income for life, but at her death the principal reverts to the children of the first marriage.

In reality, trusts for surviving spouses are usually losers in the IRA world. For after-tax assets (non-IRA or retirement assets) QTIP trusts, though far from a perfect, are often the best solution. However, for IRA owners, a QTIP trust as the beneficiary of an IRA will beg the question: Who will be most unhappy -- the surviving spouse, the children of the first marriage or the poor trustee?

A QTIP trust accelerates required income tax payments by forcing the surviving spouse and the children of the first marriage to take minimum required distributions based on the surviving spouse's age. Consequently, while the surviving spouse is alive, minimum distributions are greater than if the surviving spouse had been named outright. When the surviving spouse dies (assuming the surviving spouse predeceases the children), the children will also have an accelerated minimum required distribution schedule based on the life expectancy of their step-parent, not their own life expectancy.

Instead of setting up a QTIP trust, help the IRA owner make an explicit decision to divide the IRA between his spouse and his children from the first marriage; giving X percent to the spouse and Y percent to the children.

For example, if the value of an income stream for a 65-year-old surviving spouse based on a 6 percent rate of return is roughly 58 percent of the principal of the IRA (based on the life expectancy of the surviving spouse and depending on what tables you use), then it is simpler and preferable to leave the surviving spouse 58 percent of the IRA and the remaining 42 percent to the children. The income tax savings that can be harnessed through the stretch, for both the spouse and the children, is enormous.

By bequeathing percentages of the IRA, all of the inheriting parties assume complete control over their portion. The surviving spouse takes her share and rolls it into an IRA. There will be no RMD until she reaches age 70 1/2, so she can opt to wait to take distributions as she sees fit, and the distributions will be based on the advantageous Uniform Life Table. The children take their shares as an inherited IRA and stretch distributions based on their own life expectancies. Clean, simple and cheap.

But there are potential problems? For some of my clients, King Solomon could not decide on a percentage and make all parties happy.

Life insurance is the best solution for many, if not most, families that find themselves unable to agree. For larger estates, create an irrevocable life insurance trust with the children as beneficiaries. Dad makes regular gifts to the trustee, and the trustee uses the gifts to purchase life insurance owned by the trust. When the policy matures (i.e., Dad dies), the children get the death benefit of the policy free of income tax and free of estate tax.

If life insurance is not an acceptable option, for whatever reason, another compromise is to bequeath after-tax assets to the spouse outright and leave the IRA to the children of the first marriage to fully capitalize on the benefits of the stretch.

There are other excellent solutions that you will devise based on the individual circumstances of your client. But please, no QTIP beneficiaries for IRAs or retirement plans.

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