Planning For Tax-Qualified Plans

Planning for tax-qualified plans, which includes IRAs, 401(k)s and qualified retirement plans, requires a careful examination of the potential taxes that impact these assets. Unlike most other assets that receive a “basis step up” to current fair market value upon the owner’s death, IRAs, 401(k)s and other qualified retirement plans do not step-up to the date-of-death value. Therefore, beneficiaries who receive these assets do so subject to income tax. If your estate is subject to estate tax, the value of these assets may be further reduced by the estate tax. And if you name grandchildren or younger generations as beneficiaries, these assets may additionally be reduced by the generationskipping transfer tax. All tolled, these assets may be reduced by 70% or more.

There are several strategies available to help reduce the impact of these taxes:

  • Structure accounts to provide the longest-term payout possible.
  • Take the money out during lifetime and pay the income tax, then gift the remaining cash either outright or through an irrevocable life insurance trust.
  • Take the money out during lifetime and buy an immediate annuity to provide a guaranteed annual income, to pay the income tax, and to pay for insurance owned by a wealth replacement trust.
  • Name a Charitable Remainder Trust as beneficiary with a lifetime payout to the surviving spouse. The remaining assets would pass to charity at the second death.
  • Give the accounts to charity at death.

Structuring the accounts to provide the longest-term payout possible is the most simple and therefore the most common option. With this strategy you name beneficiaries in such a way that requires them to withdraw the least amount possible as required minimum distributions, or those distributions that must be made in order to avoid significant penalties. This can be accomplished by naming the beneficiaries individually or by directly naming their shares of a trust. Frequently, the surviving spouse is named as the primary beneficiary so that he or she may roll over the account into the surviving spouse’s name and treat it as his or her own account. Alternatively, if you are concerned the loss of creditor or divorce protection by naming the surviving spouse individually, you can name a trust for the survivor’s benefit.

Another option is to take the money out during lifetime and pay the income tax, then gift the remaining cash either outright via lifetime giving or through an irrevocable life insurance trust. If through an irrevocable life insurance trust, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds free of income and estate tax and, under certain circumstances, free of generation-skipping transfer tax.

Another option is to withdraw your IRA or qualified plan and purchase an immediate annuity, which will generate a guaranteed income stream during the lives of you and your spouse. You can use this income stream to pay the income tax caused by the withdrawal, and also pay the premiums on life insurance owned by a Wealth Replacement Trust. Again, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds from the Wealth Replacement Trust free of income and estate tax and, under certain circumstances, free of generationskipping transfer tax.

Alternatively, it may make sense to use other assets to purchase the immediate annuity, saving the IRA for family members. This strategy makes the most sense when you can defer the income tax on the IRA or qualified plan for many years by naming a very young beneficiary.

Yet another option is for you to leave the accounts to a Charitable Remainder Trust (“CRT”), described in detail under Creation of a Charitable Remainder Trust. This will allow the accounts to pass free of any estate taxes and will pay to the surviving spouse an annual income stream, either in a specified dollar amount or the lesser of the trust income or a percentage of the net fair market value of the assets.

With this option, a testamentary CRT may be established upon the death of the first of you to die. The survivor is guaranteed an annuity for his or her lifetime that will help maintain his or her lifestyle should the family’s income stream be insufficient. The property will only go to the CRT at death. It is only at death or incompetency that this aspect of your estate plan becomes irrevocable. However, even after the first death occurs, the survivor still has the ability to change which charities are to receive the assets or to bypass the CRT entirely. At the second death, the property in the CRT will pass to charity.

The final option is for you to give the accounts to charity at your death or at the death of the survivor of you. This strategy is particularly attractive if you intend to make gifts to charity at your death and the question is simply what assets should you select. As a tax-exempt entity, a qualified charity does not pay income tax and therefore receives qualified retirement plans free of income tax. In other words, if your beneficiary is in a 35% tax bracket, a $100,000 IRA is worth only $65,000 in his or her hands, but worth the full $100,000 if given to charity. Therefore, it makes economic sense to give these assets to charity and give to your children or other beneficiaries’ assets that are not subject to income tax and which receive a step-up in basis to their date-of-death value at your death.

Planning for tax-qualified plans, which includes IRAs, 401(k)s and qualified retirement plans, requires a careful examination of the potential taxes that impact these assets. Unlike most other assets that receive a “basis step up” to current fair market value upon the owner’s death, IRAs, 401(k)s and other qualified retirement plans do not step-up to the date-of-death value. Therefore, beneficiaries who receive these assets do so subject to income tax. If your estate is subject to estate tax, the value of these assets may be further reduced by the estate tax. And if you name grandchildren or younger generations as beneficiaries, these assets may additionally be reduced by the generationskipping transfer tax. All tolled, these assets may be reduced by 70% or more. There are several strategies available to help reduce the impact of these taxes: • Structure accounts to provide the longest-term payout possible. • Take the money out during lifetime and pay the income tax, then gift the remaining cash either outright or through an irrevocable life insurance trust. • Take the money out during lifetime and buy an immediate annuity to provide a guaranteed annual income, to pay the income tax, and to pay for insurance owned by a wealth replacement trust. • Name a Charitable Remainder Trust as beneficiary with a lifetime payout to the surviving spouse. The remaining assets would pass to charity at the second death. • Give the accounts to charity at death. Structuring the accounts to provide the longest-term payout possible is the most simple and therefore the most common option. With this strategy you name beneficiaries in such a way that requires them to withdraw the least amount possible as required minimum distributions, or those distributions that must be made in order to avoid significant penalties. This can be accomplished by naming the beneficiaries individually or by directly naming their shares of a trust. Frequently, the surviving spouse is named as the primary beneficiary so that he or she may roll over the account into the surviving spouse’s name and treat it as his or her own account. Alternatively, if you are concerned the loss of creditor or divorce protection by naming the surviving spouse individually, you can name a trust for the survivor’s benefit. Another option is to take the money out during lifetime and pay the income tax, then gift the remaining cash either outright via lifetime giving or through an irrevocable life insurance trust. If through an irrevocable life insurance trust, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds free of income and estate tax and, under certain circumstances, free of generation-skipping transfer tax. Another option is to withdraw your IRA or qualified plan and purchase an immediate annuity, which will generate a guaranteed income stream during the lives of you and your spouse. You can use this income stream to pay the income tax caused by the withdrawal, and also pay the premiums on life insurance owned by a Wealth Replacement Trust. Again, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds from the Wealth Replacement Trust free of income and estate tax and, under certain circumstances, free of generationskipping transfer tax. Alternatively, it may make sense to use other assets to purchase the immediate annuity, saving the IRA for family members. This strategy makes the most sense when you can defer the income tax on the IRA or qualified plan for many years by naming a very young beneficiary. Yet another option is for you to leave the accounts to a Charitable Remainder Trust (“CRT”), described in detail under Creation of a Charitable Remainder Trust. This will allow the accounts to pass free of any estate taxes and will pay to the surviving spouse an annual income stream, either in a specified dollar amount or the lesser of the trust income or a percentage of the net fair market value of the assets. With this option, a testamentary CRT may be established upon the death of the first of you to die. The survivor is guaranteed an annuity for his or her lifetime that will help maintain his or her lifestyle should the family’s income stream be insufficient. The property will only go to the CRT at death. It is only at death or incompetency that this aspect of your estate plan becomes irrevocable. However, even after the first death occurs, the survivor still has the ability to change which charities are to receive the assets or to bypass the CRT entirely. At the second death, the property in the CRT will pass to charity. The final option is for you to give the accounts to charity at your death or at the death of the survivor of you. This strategy is particularly attractive if you intend to make gifts to charity at your death and the question is simply what assets should you select. As a tax-exempt entity, a qualified charity does not pay income tax and therefore receives qualified retirement plans free of income tax. In other words, if your beneficiary is in a 35% tax bracket, a $100,000 IRA is worth only $65,000 in his or her hands, but worth the full $100,000 if given to charity. Therefore, it makes economic sense to give these assets to charity and give to your children or other beneficiaries’ assets that are not subject to income tax and which receive a step-up in basis to their date-of-death value at your death.

Stay Bonus

A Stay Bonus is an inducement to your key employees to remain with the company after your death to preserve the enterprise value of the business. It is a contract with your key employees that provides that they will receive a significant bonus in every paycheck for a two or three year period after your death if they stay with the company.

The Stay Bonus is funded with life insurance on your life. This life insurance is owned by an irrevocable life insurance trust that is earmarked to pay the bonus. Since the life insurance is owned by the life insurance trust, the insurance proceeds will not be subject to estate tax at your death.

What You Should Know About Divorce and Estate Planning

Going through a divorce is very traumatic. There can be hard feelings. There are dozens of difficult decisions to be made and papers to be signed. It creates a serious disruption of your life and it may take you some time to recover. During this time of trauma and disturbance some things may be overlooked. Tragically, one of those often overlooked details is your estate plan.

Your estate plan is meant to keep you in control of your finances and healthcare during times of mental incapacity and death by allowing you to specify who will assist you. If you do not update your plan during or soon after your divorce you may no longer be in control. Your original plan was created under a specific set of circumstances that no longer exists. Maintenance and updating of your plan is necessary and critical to providing for your loved ones and ensuring that you do not leave them a big mess.

Whether you realize it or not, you have an estate plan, or at least some pieces of a plan. Included in your estate plan may be the well known estate planning tools - the Will, trust, and durable powers of attorney. Also part of your estate and plan are the less obvious life insurance policies and retirement accounts.

Should I Do Anything Before the Dissolution Is Final?

 

If you die before the divorce is final and you do not have a formal estate plan, your spouse is entitled to your one-half of the community property and up to 100% of your separate property. If you have living children, living parents, living siblings, or living nieces or nephews your spouse is entitled to the community property and one-half to three-quarters of your separate property. Life insurance policies and retirement accounts are controlled by beneficiary designations, and if you are like most people, your spouse is probably named as the primary beneficiary.

If you have a formal plan in place (Will, Trust, Durable Powers of Attorney) the plan will control. But, you have most likely named your spouse as your primary beneficiary, trustee, personal representative, attorney-in-fact, and agent.

If you no longer want your spouse to share in your estate, you will either need to amend your estate plan or create a formal plan. You should also change the beneficiary designations for your retirement accounts and life insurance policies as soon as possible. You will need your spouse’s consent if you do not name your spouse as the primary beneficiary for your retirement accounts.

 

I Didnt Do Anything Before the Divorce Was Final - What Do I Need To Do Now?

 

Minor Children and Guardianship

If you do not have a trust and you have young children, now may be the right to time create one. If something should happen to you, either a mental disability or death, your former spouse will have full custody of the children. If you leave assets to your children and they are minors you create two problems.

First, someone will need to petition the court to become guardian of the estate to control the assets. Second, that someone is likely to be your former spouse. By leaving your assets in a trust for your children you control who manages the money and the need for a guardianship is eliminated.

 

Wills and Durable Powers of Attorney

The state of Washington has helped you out when it comes to your Will, Financial Durable Power of Attorney and Health Care Power of Attorney. Upon divorce, your Will automatically treats your former spouse as predeceasing you and any gift to the former spouse or naming of the former spouse as your executor will be revoked. The same is true for your Financial Durable Power of Attorney and Health Care Power of Attorney. If you named your former spouse as your attorney-in-fact or agent that nomination will be automatically revoked.

While these automatic revocations offer protection, many times an alternate to your former spouse has not been named. This can create uncertainty and chaos for those you leave behind and in the case of a mental disability, may create the need for a court supervised conservatorship. To avoid these problems you should have your Will, Financial Durable Power of Attorney and Health Care Power of Attorney redrafted. In addition, because of the divorce your goals may have changed for your estate plan. These changes should be reflected in a new plan.

Trusts and Other Estate Plan Pieces

Washington also has an automatic revocation for the transfer of some non-probate assets like beneficiary designations. However, this provision should not be relied on. If you you look at the law that creates this revocation you will see many exceptions to the rule. Additionally, third parties who are unaware of your divorce are not liable for transferring your assets to your ex-spouse. Remember, the beneficiary designation controls. You should immediately change the beneficiaries of your life insurance and retirement accounts.

If you have a trust, the trust remains in effect, and if it is a joint trust, your former spouse remains as a trustee of the trust. Even if your trust provides language dealing with divorce or the automatic revocation law can be applied to your trust, you should revoke the trust and create a new trust tailored to your new situation and goals.

What is Estate Planning?

Let’s start with what it isn’t. Estate planning is not just for the wealthy. It is not just about avoiding probate and minimizing taxes. It is not just transferring wealth at your death. It is not about which documents to use. It is not a one-time event.

It is about your family, their needs, and your goals. It is about taking care of you and your loved ones at all stages of your life. It is about results and meeting your expectations. A proper estate plan most importantly ensures and provides detailed, clear, comprehensive, customized instructions for handling your affairs in times of mental disability or death. If it is relevant, your plan should also ensure that your estate avoids the cost and delay of probate and that estate taxes are minimized. A proper plan coordinates beneficiary designations for your life insurance and retirement accounts to maximize plan benefits in accordance with your goals. If you are a business owner, your plan should also provide a mechanism for business succession. Most importantly, a proper plan keeps you in control of your estate.

Proper planning starts with a thorough understanding of your needs, goals, dreams and aspirations. It includes developing a thorough understanding of your family and its dynamics, those who you care about and who will someday receive the benefits of your success. Family can be defined in many ways. For some people, family includes children and grandchildren. For others, it may be friends or community, nieces, nephews or other loved ones. Unfortunately, most plans are built on tax planning instead of family planning; resulting in plans that don’t work. Personal family concerns and goals are given a lower priority, if they are discussed at all, instead of being the very foundation of the plan.

Plans don’t work because they are treated as a transaction rather than an ongoing process. Many people say “I did my estate plan,” and then put it on the shelf to collect dust. Because everything constantly changes, your plan must be constantly changing too. Plans that work require ongoing maintenance to fine tune them to your changing goals, family circumstances, and changes in the law. Plans that work also require education of you and your “helpers” – those individuals who will carry through with your plan when you can no longer do so. The most thorough custom tailored plans won’t work if the person carrying it out doesn’t know what they are supposed to be doing. Education is the key.

Plans also don’t work because much of what passes for estate planning is little more than word processing. You are asked a few questions and then the drafter decides which “plan” is right for you and fits you in a box. This is not planning – this is simply document preparation. You shouldn't pay a licensed professional to do word processing. Their value is in their counsel and advice, based on knowledge, wisdom and experience. A proper estate plan meets your goals and expectations, and keeps you in control of the process and the results.

To ensure a proper plan, work with a counseling oriented attorney who will educate you and your helpers, who takes the time to get to know you, your family, your desires, your concerns, your goals, and your potential problems, who will gladly and patiently answer all your questions, no matter how small, until you understand the concept or issue, and who has dealt with the problems and results caused by poor planning.

Annuities

An annuity is a contract between you, the contract owner, and an insurance company for a fixed or increasing payment. The contract owner contributes funds to the annuity in exchange for an income stream for a specified number of years, for life, or for the joint lives of you and your spouse. Commencement of annuity payments (“annuitization”) can start immediately (“an immediate annuity”) or in the future (“a deferred annuity”).

The growth of the annuity value during the accumulation phase is tax deferred. If an annuity was purchased inside a qualified pension plan or IRA, then 100% of the annuity payment is taxable as ordinary income upon distribution. If the annuity contract is purchased with after-tax dollars, then the policyholder upon annuitization recovers his basis (that is, cost to purchase the annuity) pro-rata in the ratio of basis divided by the expected value. After the taxpayer has recovered all of his or her basis, then 100% of the payments thereafter are subject to ordinary income tax.

There are two basic types of annuities, fixed and variable annuities. With a fixed annuity, the insurance company guarantees a minimum return within the annuity, while also typically guaranteeing a minimum annuity benefit. The insurance company bears all risk of meeting these guarantees.

Alternatively, variable annuities have no guarantees as to return or annuity benefit. The contract owner invests the funds by selecting various sub-accounts, which operate similar to mutual funds. The contract owner bears all of the risk with variable annuities.