According to the U.S. Census Bureau, “blended families” now outnumber traditional nuclear families. The trend is expected to continue as the divorce rate climbs and life expectancy increases, creating a larger pool of eligible widows and widowers. Estate planning for the blended family is complex and potentially damaging to family relationships. If both spouses in a second marriage have children by a prior marriage, they have conflicting responsibilities and wishes. If the marriage is a happy one, each spouse wants to provide for the other in their Will or Trust. On the other hand, they do not want to disinherit their children by a prior marriage. Without planning, the surviving spouse could become the outright owner of all of the couple’s combined assets, free to leave them to a new spouse or his or her children. If the surviving spouse does not get along with the stepchildren, this is likely to happen, leaving the stepchildren with no legal recourse. What can be done to prevent this from happening?
Pre-Nuptial and Post-Nuptial Agreements
Planning before the marriage is always a good option. With a Pre-Nuptial Agreement, each partner must disclose what his or her assets are and what their financial liabilities are (alimony, child support, credit card and mortgage debt). The Agreement spells out how the couple will contribute to their living expenses after marriage, how assets acquired during the marriage will be treated, how their assets will be divided in the event of divorce, and what each other will inherit when a spouse dies. Further, there are provisions in the Agreement that the spouses will not take actions to interfere with each other’s estate plans, such as contesting a Will. The Agreement also recognizes that the spouses may make gifts to each other during the marriage and may rewrite their existing estate planning documents to include the new spouse as a beneficiary. If you did not enter into a Pre-nuptial Agreement before marriage, a Post-Nuptial Agreement is an option. Many states, including Massachusetts, now recognize the validity of the Post-Nuptial Agreement, which is entered into after a couple is married.
The Importance of Beneficiary Designations
Do you want your former spouse to collect the benefits as the beneficiary of your life insurance policy or IRA account because you forgot to update the beneficiary designation after your divorce? This was an issue decided in a recent federal Appeals Court case. While a divorce decree will nullify all references to a former spouse in your Will, Trust, Power of Attorney, and other estate planning documents, the divorce decree will not change your beneficiary designation for life insurance policies and retirement accounts. Only you can change the beneficiary designations. The Appeals Court case was based on the following facts. After divorcing his first wife, the husband remarried and remained married to his second wife for twenty-seven years before his death. All of the husband’s estate planning documents, which had been redrafted after the divorce, named his new wife as the primary beneficiary of his estate. However, he had neglected to change the beneficiary designation for a life insurance policy that paid out benefits of $250,000 after his death. Although it was clear from the divorce decree and the husband’s new estate planning documents that he did not want the death benefits payable under this policy to go to his former wife, the Court held that it was not their job to be mind readers – maybe he was still fond of his first wife and wanted to leave this money to her. The Court also held that it was not proper for the Court to amend a beneficiary designation for a life insurance policy. How could anyone have confidence that their beneficiary designations would be honored by the insurance policy if a Court could change the designation? The Court upheld the beneficiary designation and the first wife collected the $250,000. I tell all of my clients to obtain copies of all beneficiary designations for life insurance policies, IRA and 401-k accounts, and annuities as part of the estate planning process. This is critical after a divorce. The divorce decree will not amend a beneficiary designation – you must fill out and sign the form.
Many people are surprised to see who the beneficiaries of their life insurance policies and retirement accounts are. Before you are married, you are likely to name your parents or siblings as the beneficiaries of the group term insurance policy and the 401-k account that are benefits of your first job. After you marry, that beneficiary designation will stay in place unless you fill out a new beneficiary designation form for each policy and retirement account. When children come along, they will not be added as beneficiaries unless you add them. If there is a divorce, your new spouse will not become a beneficiary unless you fill out a new form. And after the death of a spouse, you should always check to make sure that you have named contingent beneficiaries of your life insurance policies and retirement accounts. When their children are young, some parents name the person who will be the child’s legal guardian as the contingent beneficiary of their life insurance policies. If a guardian must be appointed after both parents are deceased, the parents trust the legal guardian to use the insurance proceeds for the benefit of their children. The problem is that the parents neglect to change the beneficiary designation when the children are older and should be named as the contingent beneficiaries. The older the insurance policy, the most likely it is that there may be an outdated beneficiary designation form.
The Appropriate Estate Plan
In a traditional estate plan, each spouse leaves his or her assets to the surviving spouse, giving the surviving spouse complete access to and control over the couple’s combined assets, with the understanding that these assets will pass to their children after the death of the surviving spouse. This planning approach works well for the traditional nuclear marriage, where the only children involved are the ones that the couple have together. This type of plan is probably not the best one for families that don’t fit this traditional definition. For couples with children from prior marriages, a better approach is to sort out what’s “yours, mine, and ours” and plan accordingly, so you do not unintentionally disinherit your current spouse or any of your children. You must think carefully and objectively about the present and future financial needs of your spouse and children, potential conflicts, and what you believe is fair to all involved. Most estate plans have two or three goals: (1) to determine who will receive which assets, and when; (2) to avoid probate; and (3) to reduce or minimize estate taxes. The first goal generally can be accomplished in a variety of ways, including:
- Providing for family members in a Will or a Trust;
- Naming your spouse and/or children as joint owners of real estate, bank, accounts, stocks, bonds, and other investments; and
- Designating your spouse and children as the primary and contingent beneficiaries of your life insurance policies, annuities, IRA accounts, 401(k) plans, and other tax-deferred retirement plans and accounts.
The second goal requires a little more planning, but can easily be accomplished by establishing and funding one or more Trusts established during your lifetime. The third goal calls for more sophisticated strategies. See the
Estate and Gift Tax page for a description of planning techniques to reduce or eliminate liability for federal and Massachusetts estate taxes. With the unlimited federal and Massachusetts estate tax marital deduction, you can give your spouse an unlimited amount of assets, free of gift and estate taxes. If you leave your entire estate outright to your surviving spouse, as the beneficiary of your Will or Trust, as the surviving joint owner of your assets, or as the primary beneficiary of life insurance policies, annuities, and retirement plans and accounts, no estate taxes will be due from your estate after your death. However, if you leave all of your assets outright to your spouse, and he or she outlives you, you will relinquish control over who will receive the assets after your spouse’s death. When your spouse dies, the assets that he or she owns will pass under the terms of his or her Will or Trust. If a couple both have children by prior marriages, the surviving spouse is not legally obligated to leave any assets to the deceased spouse’s children. This is true if the spouse inherits under a Will, becomes the owner of jointly held assets, or is named as the primary beneficiary of tax-deferred retirement accounts. Even if you name your children as the contingent beneficiaries of your IRA and 401(k) accounts, if your spouse chooses to rollover the funds in these accounts into a spousal IRA, he or she is free to name whoever they wish as the beneficiary of the new IRA account.
If you and your spouse have children by a prior marriage, you probably have two potentially conflicting goals. You want to make sure that your spouse will be supported comfortably if you are the first to die, and you want to ensure that all children involved will be treated fairly after both of you are deceased. There are several different planning techniques that will accomplish these goals.
Establish and Fund One or More Trusts
If estate taxes are not an issue, you and your spouse can establish one Revocable Trust (also referred to as a “Living Trust”) that will be funded with your joint assets. While both of you are living, the Trust may be amended or terminated by written agreement signed by both of you. Both of you may serve as Trustee, having joint authority over the management and investment of the trust assets. It is very important to address the issue of how the Trust will be administered after the death of a spouse. The Trust may continue to be revocable after the death of a spouse or the Trust may become irrevocable after the death of a spouse. There are reasons for the Trust to remain revocable after the death of one spouse. The surviving spouse may want to change the names of the Successor Trustees or the ages at which the children will receive outright distributions after both spouses are deceased. This is a common choice when the only children involved are the children that the couple have together. This is not a good choice when each spouse has children by another marriage. In this case, it is advisable to name a family member to serve as Co-Trustee with the surviving spouse, to make sure that the trust funds are being used for the surviving spouse’s maintenance and support, as directed in the trust agreement, and the funds not needed for support are being conserved and invested for the benefit of the couple’s children.
It is critical that the Trust is irrevocable at this stage in trust administration
It is not unusual for a surviving spouse to rewrite the terms of a Trust after the death of a spouse if he or she has the authority to do so. If the surviving spouse has the right to amend the trust, the surviving spouse has the ability to disinherit the other spouse’s children. If the Trust is irrevocable, the provisions for distributions to the couple’s children cannot be changed after the death of a spouse. And if there are limits on how the surviving spouse can use the trust funds, there will be funds left to distribute to the couple’s children. Establishing and funding a Trust has the added advantage of avoiding probate. Establishing and funding certain types of Trust will also minimize or eliminate liability for estate taxes.
One way to make use of the marital deduction and control who will receive your assets after your spouse’s death is to create a Qualified Terminable Interest Property (“QTIP”) Trust. This Trust is created under the terms of a Revocable Trust established during your lifetime. You may retain complete control over your Revocable Trust during your lifetime. After your death, the trust becomes irrevocable, and some, or all of the trust assets will fund a QTIP Trust. The QTIP Trust will be managed for your spouse’s benefit during his or her lifetime. Upon his or her death, the assets remaining in the QTIP will pass to the beneficiaries named by you in the trust agreement. As long as the QTIP Trust meets these requirements, it will qualify for the marital deduction.
- Your surviving spouse must be entitled to all trust income, payable annually or more frequently, for life.
- No person can have a power to distribute trust property to anyone other than your spouse while your spouse is alive.
- Your executor must elect to treat the trust as marital deduction property on the Estate Tax Returns filed for your estate.
Your spouse’s estate may have to pay federal or Massachusetts estate taxes on the assets remaining in the Q-TIP Trust after his or her death, depending on the value of the other assets in his or her taxable estate, but the assets remaining in the QTIP Trust after your spouse’s death must be distributed as you have directed in the trust agreement.
A Two-Part Estate Plan
A QTIP Trust isn’t the answer for everyone. In cases where a person with adult children from a previous marriage has a considerably younger second spouse, the children may have to wait a long time before they can benefit from the QTIP assets. In this case, a better way of providing for your spouse and children may be to divide your estate into two parts. You may give one part to your children, either outright or in a trust that takes advantage of the Massachusetts and federal estate tax exemptions. As long as the amount given to your children does not exceed the estate tax exemptions in effect at the time of your death, no estate taxes will be due from the amount given to your children. The second part of your estate is placed in a trust that qualifies for the marital deduction, such as a QTIP trust. No estate taxes will be due on the assets funding the marital trust. When your spouse subsequently dies, the assets that remain in the QTIP Trust will be distributed to your children. Estate taxes may be due at this point, depending on the value of the assets remaining in the QTIP Trust and the other assets in the surviving spouse’s taxable estate.
Life Insurance Trusts
An Irrevocable Life Insurance Trust (ILIT) is another strategy that is used by individuals with large amounts of life insurance. This also works well for blended families. When the ILIT is established, the insured transfers ownership of the policies to the Trustee of the ILIT. With a properly drafted and administered ILIT, the death benefits are not included in your taxable estate. The Trust is irrevocable, so the terms of the Trust cannot be changed at any time. Some, or all, of the life insurance proceeds collected by the Trustee of the ILIT after your death may be used for the support of your surviving spouse. You may choose to have some of the proceeds distributed to your children. After both you and your spouse are deceased, all of the remaining death benefits will be distributed to your beneficiaries, as directed in the trust agreement. In contrast, if you name your spouse as the primary beneficiary of your life insurance policies, he or she is free to do what they wish with the death benefits, with no obligation to leave any of the funds to your children.
Making lifetime gifts to children or other family members now gives you complete control over who will receive your assets, reduces your taxable estate, and lets you watch your beneficiaries enjoy the gifts. Massachusetts does not have a gift tax, so you can make gifts without worrying about paying taxes to Massachusetts. Under current federal laws, you can gift $13,000 per year to any number of individuals. This gift does not have to be reported on a Gift Tax Return and will not use any of your federal gift and estate tax exemption. If you wish to gift more than this amount, you will not have to pay gift taxes unless the value of the additional gifts exceeds $5,000,000 during your lifetime. This new gift tax exemption is the result of federal legislation passed in late December 2010. Many people gift assets that are appreciating in value, such as stock and real estate. That way, both the current value of the gift and any future appreciation of the assets will escape federal and Massachusetts estate taxes.
When a Business is Involved
Transferring a business interest requires additional planning. You can pass your business to children or other family members by:
• Bringing in a child or other relative as a co-owner who will buy your share of the business at your retirement or death;
• Selling the business to family members now in installments;
• Making lifetime gifts of company stock to them; or
• Leaving stock to the family members who will continue the business.
Each of these possibilities has different tax consequences that you should discuss with your attorney and accountant. If you plan to sell your business to a family member, a buy-sell agreement may be the answer to your succession planning needs. A buy-sell agreement:
• Provides for an orderly transfer of the business;
• Permits family members and other present owners to continue in their business roles after your disability, retirement or death;
• Allows a fair market price for the business to be agreed upon today;
• Provides a plan to fund the purchase; and
• Lets you plan your estate and taxes ahead of time.
Life insurance is a popular way to provide the cash needed to complete the buyout. You also can use life insurance to provide your family with the funds needed to pay estate taxes or to provide for your spouse if your business is your major asset and you transfer it to your children. Without this type of planning, a spouse with no business experience might become the owner by default, or a second spouse may leave the business to his or her children by a prior marriage.
Attorney Roberta A. Schreiber has more than thirty years of experience in this field. Planning for the blended family is not easy. However, Roberta has been involved, after the fact, in far too many situations when lack of appropriate planning has led to irrevocable family disputes, lawsuits, and disinherited children. This is one type of planning that you should not put off. If you are entering into a second marriage, the best option is the Pre-Nuptial Agreement. If you have not entered into a Pre-Nuptial Agreement, there are many other options available to you and your spouse, to ensure that the surviving spouse will be supported, and all of the children will be treated fairly. If you would like to schedule an appointment to review your planning options, please