How do I protect my spouse without disinheriting my kids?
Second marriages can be complicated, especially if you have children from your first marriage. You want to protect your current spouse, but also you 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 can 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 situation.
One way this can be addressed is to leave your assets to a marital trust. A marital trust is a special kind of trust defined in the Internal Revenue Code. The spouse must be the only primary beneficiary. However, your children can be named as contingent beneficiaries. A properly worded marital trust can protect your assets so that they ultimately benefit your heirs.
The trust terms can allow your spouse to live off the income and principal for life. With estate taxes in flux, a marital trust will also bypass estate taxes at the first death. If you live in Massachusetts, this is particularly relevant to you, as Massachusetts taxes the entire estate if the taxable estate is over $1 million. 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 $1 million exemption is wasted. By properly structuring trusts that can benefit your spouse while they are alive, you can protect an extra $1 million and potentially save $50K-$60K in estate taxes.
Trusts do have costs – once the first party passes away, the trust becomes irrevocable and will require separate accounting and a separate tax filing every year. In addition, trusts require someone (the trustee) to administer them in accordance with the terms of the trust document. Because of these requirements, trusts are best established for assets that will exceed $500K or so.
Trust taxation is also being discussed in pending legislation. If legislation passes that impacts these rules, we will update our blog.
The Beneficiary Designation – If You Have More Than Enough
If you have more than enough assets to provide for your spouse, then 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 can end up saving your family a lot of tax dollars.
IRAs/401(k)s/403(b)s and other tax-deferred assets are best left to your spouse, charity or your children, for tax reasons. If left to charity, taxes are completely avoided and the charity receives the full amount of the distribution. If left to your spouse, the tax hit can be spread over their lifetime. If left to almost anyone else, they have to empty (and be taxed on) the account over 10 years (minor children are extended to 10 years beyond the age of majority).
You can also split how the account is inherited, so a portion goes to charity and a portion to your heirs.
If your 401(k) or 403(b) has a Roth component, this should be factored in before making a beneficiary decision. Roth accounts grow tax free. They have the same rules as above regarding when they have to be emptied.
You can make the above changes easily using a beneficiary designation. This allows you to change your mind at any time without incurring additional legal costs. Beneficiaries can be changed easily at your financial institution.
Naming beneficiaries in this direct manner does not involve a trust, and so it is very easy and inexpensive to implement and administer.
A better asset to leave directly to your spouse or children may be your Roth IRA. Roth IRA distributions are tax free. If left to your spouse, they can let the assets continue to grow and are not required to take minimum required distributions. If left to almost anyone else, they have to empty the account over 10 years (minor children are extended to 10 years beyond the age of majority). However, there is no tax associated with Roth IRA distributions.
Under current law, brokerage account assets receive a step-up in basis at death and are great assets for heirs to inherit. This means that if the investments in the account were purchased for $500,000 but are worth $2 million at death, the resulting $1.5 million gain would escape income taxes. This could all change if significant tax reform is passed in 2021; we will let you know whether that happens.
No matter whom you name using a beneficiary designation, the money is inherited outright, not in trust, and can be spent in any fashion the beneficiary chooses, and they can name the future beneficiary.
There are a lot of things to consider with a second marriage. A marital trust and beneficiary designations are only a small piece 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.
Jennifer Climo, CFP®, CPA, MSFP is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.