Many individuals entering a second marriage have unique estate planning issues. Often, the assets each person brings to the marriage are unequal. Additionally, one or both individuals may wish to make provisions for their children from a prior marriage. Several tools are available to address such situations, but perhaps the two most effective are spousal agreements and qualified terminable interest property (QTIP). Both useful and flexible, these two options can suit a variety of situations.
Spousal Agreements
Frequently, individuals in second marriages will simply retitle property – either by transferring it outright to the new spouse or by retitling the property as jointly owned with a right of survivorship. The tradeoff is lack of future control. If there is a marital dissolution, the donor spouse may regret having made the gift. If the couple stays together, the surviving spouse will be free to dispose of jointly held property, as well as any property owned individually, as he or she wishes.
Such concerns are frequently addressed with premarital (or spousal) agreements. These agreements may address a broad range of issues, but their primary purpose is to remove the risk of later disagreement over the financial rights and obligations of the two parties. Typical arrangements include a complete waiver of all spousal rights that would accrue without an agreement; a requirement that one party make provisions for the other in exchange for giving up those spousal rights; and/or some arrangement concerning the sharing of property acquired during the marriage and for separate treatment of any property that is otherwise obtained.
Premarital agreements typically create contractual spousal rights, such as:
- Creation of survivorship property, by contributing assets to jointly titled accounts or a trust for the benefit of both parties
- Creation of a separate estate for the less wealthy party, by means of a cash gift, annual contributions to specified accounts, and/or agreements to transfer specific property at certain points in time
- Agreements to assume obligations of the less wealthy party, such as providing for the education of the less wealthy spouse’s children, paying off education loans, or assuming the household expenses
- Purchase of long-term care insurance for the other party
- Purchase of life insurance for the benefit of the other party (and creation of an irrevocable life insurance trust, if the size of the estate requires it)
- Creation of specified rights upon death, such as the right to some or all of a survivor annuity or other death benefits under a retirement plan; the right to have a significant asset, such as a home, upon the death of the other spouse; the right to live in the home for a specified period or until death; or the right to a specified percentage of the estate
With any such provisions, parties should seek to remove all ambiguity to avoid future litigation. Additionally, because even the best agreements are sometimes broken, the parties may want to arrange for a third party, in the form of a trustee, to help effectuate their mutual agreement.
QTIP Trusts
One of the most effective tools for controlling the disposition of one’s assets in a second marriage is a Qualified Terminable Interest Property (QTIP) trust. Properly drafted, such trusts allow an individual to provide lifetime income interest to his or her surviving spouse while ensuring that the trust’s principal will pass to one or more nonspousal beneficiaries upon the surviving spouse’s death. Additionally, the decedent’s executor will be able to claim as a marital deduction the value of the decedent’s transfer to the QTIP trust, deferring federal taxation, if any, on the trust property until the death of the surviving spouse (Internal Revenue Code Section 2056(b)(7)).
Upon the death of the surviving spouse, the value of the trust assets (as of the date of death or the alternate valuation date, if chosen) will be included in the surviving spouse’s estate for purposes of federal estate taxation. Because the QTIP trustee, rather than the surviving spouse, has title to the assets, the surviving spouse has no authority to effect their distribution by will or otherwise, and the assets pass to the beneficiaries designated by the original decedent and settlor of the QTIP trust.
Basic Requirements. Generally, the income interest to the surviving spouse will qualify for QTIP purposes if the surviving spouse is entitled to all income from the trust, to be payable at least annually, and no person has a power to appoint any part of the property to any person other than surviving spouse during the surviving spouse’s life (IRC Sec. 2056(b) (7) (B)). Once these requirements are met, the rules provide for flexibility in the other terms that the trust may have. For example, the trust may give the trustee the power to invade the trust principal for the spouse’s benefit.
Nonproductive Assets. The all-income-annually requirement does not preclude nonproductive assets from qualifying as QTIP if the spouse has the right to convert them into income-producing property (Regulation Section 20.2056(b)-7(d) (2)). For property held in trust, this right exists if applicable local law gives the spouse the right to require that the trustee either make the trust property productive or sell the property and reinvest in productive property within a reasonable time after the decedent’s death (Reg. Sec. 20.2056(b)-7(h)).
Basic Step-up. An individual with older children from a first marriage may prefer that they do not have to wait to receive certain property. In that case, the individual may choose to make lifetime gifts. However, while lifetime gifts may provide estate-tax advantages, for income-tax planning purposes, testamentary gifts can be a batter strategy. Assuming the property has appreciated, the recipients can benefit from the “stepped-up basis” rules under IRC Sec. 1014 if they later sell the property. For larger gifts, such as the primary residence, the decedent might save even more income tax for the heirs by placing the assets in a QTIP trust. Assuming the individual predeceases his or her spouse, the value of the asset at the time of the surviving spouse’s subsequent death would become the basis of the asset in the hands of the beneficiary who receives the asset from the trust (IRC Sec. 1014(b) (10)).
Retirement Assets
In many ways, tax-favored retirement assets are unique. The Employee Retirement Income Security Act of 1974 (ERISA) governs the way in which assets in qualified retirement plans sponsored by employers may be handled. In addition, the IRS administers a large number of statutes and regulations that govern such assets.
Spousal Rights. In a qualified retirement plan, absent a qualified waiver, the account holder’s surviving spouse is generally entitled to a qualified survivor annuity unless the plan provides that, upon the participant’s death, the vested benefit is payable in full to the surviving spouse or the participant does not elect the payment in the form of a life annuity (IRC Sec. 401(a) (11) (A)). Most defined contribution plans, such as 401(k) plans, do not provide for an annuity, but they are required to make payment in full of a married participant’s nonforfeitable accrued benefit to the surviving spouse on the participant’s death unless there is a qualified waiver in place and the spouse has consented to it.
Very strict and technical rules govern waivers of spousal rights. A participant’s election to waive his or her spouse’s survivorship rights in pension benefits is not valid unless (1) the affected spouse consents in writing to the election, (2) the election designates a beneficiary, which may not be changed without spousal consent, or the spouse consents to allow future designations by the participant without the spouse’s consent, and (3) the spouse’s consent acknowledges the effect of the election and is witnessed by a plan representative or a notary public (IRC Sec. 417(a)(2)(A)).
Additionally, in a plan subject to the qualified survivor annuity requirements, an election to waive a qualified preretirement survivor annuity (with spousal consent) can be made only on or after the first day of the plan year in which the participant reaches age 35 unless the plan provides for an earlier waiver. An earlier waiver becomes invalid at the start of the plan year in which the participant turns 35, and absent a new waiver, the participant’s spouse must receive the qualified preretirement survivor annuity on the participant’s death (Reg. Sec. 1.401(a)-20, Q&A 33(b)). Consent to waive the qualified joint and survivor annuity is effective only if it is signed within the 180-day period ending on the annuity start date (IRC Sec. 417(a) (6)).
QTIP Trust as Beneficiary. An additional issue concerns the proper treatment of retirement assets for which the beneficiary is a QTIP trust. Because such assets do not produce “income” unless distributions are made, the IRS has provided illustrations of three situations where a surviving spouse will be considered to have a “qualifying income interest for life” in retirement assets (including individual retirement accounts) for QTIP election purposes. Very generally, the IRS has stated in Revenue Ruling 2006-26 that an income interest will qualify if:
- The trustee is authorized to make adjustments between the income and principal under a state law provision similar to Section 104 of the Uniform Principal and Income Act (UPIA)
- The trustee determines the income of the trust (excluding the IRA) and the income of the IRA under a qualifying statutory unitrust regime
- The surviving spouse has the power to compel the trustee to withdraw the income of the IRA as determined under the law of jurisdiction
Although individuals anticipating a second marriage have several options, the two most commonly used are the premarital agreement and the QTIP trust. Not only may these be helpful in effecting both an equitable property arrangement and protection of children from a prior marriage, but they are malleable enough to suit many different situations.