Second marriages can be complicated, especially if you have children from your first marriage. You want to protect your current spouse, but you also want to make sure your children inherit assets at some point. If you leave everything to your current spouse, there is the possibility that your spouse could change their beneficiaries to include someone other than your children in the future, leaving your children without an inheritance. Below, we will discuss two ways to pass on your assets in a second marriage.  

Marital Trusts 

One approach is to leave assets to a qualified terminable interest property (QTIP) trust. A QTIP trust is a special type of marital trust defined in the Internal Revenue Code and elected by the decedent’s personal representative. The surviving spouse must be the only income beneficiary and must receive all trust income during their lifetime. In addition to income distributions during the surviving spouse’s lifetime, the trust terms may permit distributions of principal to support your spouse. After your spouse passes, the QTIP trust assets pass to the remainder beneficiaries, who could be your children or someone else you designate in the trust. A properly drafted QTIP trust can provide financial security for your surviving spouse while ensuring that your children receive the remaining assets.  

Under federal estate tax law, married individuals may pass an unlimited amount of “marital property” to each other at death with no estate tax due. Assets in a QTIP trust qualify for the marital deduction, so no estate tax is due upon the death of the first spouse. However, assets passed to the surviving spouse, including those in a QTIP trust, are included in that person’s estate when they die. On the plus side, the assets going into a QTIP trust will receive a step-up in basis at your death. Since any remaining assets in the QTIP trust must also go through your spouse’s estate at their death, the assets will receive a second step-up at that time.  

If your estate is large enough to be impacted by federal estate taxes, and/or if you live in a state with a low estate tax exemption amount, you should speak with your estate attorney about structuring an estate plan that provides for estate tax savings. This will typically involve setting up a different type of trust known as a credit shelter or bypass trust.  

If you live in Massachusetts, this is particularly relevant to you, as Massachusetts taxes estates worth more than $2 million, and spouses are limited to just their own individual exemption amount. If you own a home in Massachusetts and have a 401(k) and some life insurance, you could easily find yourself over that limit. If you leave everything to your spouse, your spouse won’t pay any estate taxes, but then your $2 million exemption is wasted and your heirs will pay taxes on the combined estate that exceeds $2 million. By properly structuring trusts that can benefit your spouse while they are alive, you can potentially protect $2 million, possibly saving five to six figures in Massachusetts estate taxes. 

Trusts do come with costs. When you (the grantor) pass away, the trust becomes irrevocable and will require a separate accounting and separate tax filing every year. In addition, there must be a trustee to administer the trust in accordance with the terms of the trust document. Sometimes a family member is willing and competent to do this job; other times a professional trustee is required and must be compensated. Because of these requirements, trusts are best established when assets exceed approximately $500,000.  

What About My House? 

If you leave your house to your children outright, your spouse could be without a place to live upon your death. A QTIP trust can include a provision to allow your spouse to remain in the house until their death, and even to substitute a different property, in case they want to move. This is especially important if they want to move to a Continuing Care Retirement Community later in life.  

The Beneficiary Designation – If You Have More Than Enough Assets 

If you have more than enough assets to provide for your spouse, you may want to leave some of your assets directly to your children (or others) or to a charity. Different assets have different tax attributes and, depending on your goals, paying attention to these differences can end up saving your family a lot of tax dollars.  

Your Traditional IRAs, 401(k)s/403(b)s and Thrift Savings Plans 

For tax reasons, individual retirement accounts (IRAs), 401(k)/403(b) plans, thrift savings plans and other tax-deferred assets are best left to your spouse, to charity or to your children. If retirement assets are left to charity, taxes are completely avoided and the charity receives the full amount of the distribution. If you leave these assets to your spouse, the tax hit can be spread over your spouse’s remaining life. If you leave your retirement assets to almost anyone else, the tax hit can be more significant. With certain exceptions, the account generally must be emptied within 10 years after your year of death.  

You may split how an account is inherited. A portion may go to charity while the remainder goes to your heirs.  

Your Roth IRAs, 401(k)s and 403(b)s 

Roth IRAs and 401(k) and 403(b) plans with a Roth option have different tax advantages from traditional retirement plans. You will want to consider these advantages – tax-free growth and tax-exempt distributions – when naming your beneficiary(ies). For example, charities are not good beneficiary candidates for Roth IRAs because tax advantages are lost on charities. However, Roth IRAs are excellent wealth transfer vehicles for spouses and other beneficiaries. Note that the same withdrawal rules as above apply regarding when Roth accounts must be emptied.  

Brokerage Accounts 

You may name beneficiary(ies) on a regular brokerage account by adding a transfer on death (TOD) or payable on death (POD) to the account.  

Under current law, non-retirement brokerage account assets receive a step-up in basis at death and are great assets to inherit. This means that if the investments in the account were purchased for $500,000 and are worth $2 million at death, the resulting $1.5 million gain escapes capital gain taxes and the cost basis of the inherited assets is “stepped up” to $2 million.  

Beneficiary changes are easily made using a beneficiary designation form obtained from your financial institution. Many accounts also permit beneficiary changes to be made online. There is no cost to update your beneficiary designation as there would be for, say, revising your trust document with your attorney. 

It is important to check your beneficiary designations periodically to ensure that they are accurate and up to date and reflect your wishes. Changes in life circumstances, such as divorce or remarriage, should always prompt a review of your beneficiaries on file.  

Using a beneficiary designation as an alternative to setting up a trust is simpler and less expensive, but the trade-off is less control by the original owner. When you name an individual beneficiary, that person receives the assets outright and has control over spending as well as who should inherit down the road.  

Conclusion 

There are a lot of things to consider with a second marriage. A marital QTIP trust and beneficiary designations are only two small pieces of an overall estate plan. We recommend you meet with a fee-only financial advisor to help you work with your estate planning attorney to draft all the documents you need to protect your family.  If you need assistance with your tax planning or retirement planning in general, please reach out to our team.