The estate planning complexities surrounding second marriages with blended families are largely under-estimated, not only by clients, but by their attorneys. Since second (and even third) marriages are becoming more common, it is not unusual for a married couple to each have adult children from prior marriages. When you link these parties in an estate plan, sometimes things can go terribly wrong.
When completing estate plans in second marriage situations, the challenge includes how to provide for one’s surviving spouse for the rest of her or his life, while at the same time preserving assets and equity for one’s children. The typical response is a “Marital” or “QTIP” trust that pays the surviving spouse income and may also provide for discretionary principal distributions for the spouse’s health, maintenance and support. At the surviving spouse’s death, the remaining assets of the Marital Trust are then distributed to the children.
While such Marital Trusts are useful tools to accomplish these goals, careful and deliberate consideration should be given to a variety of factors that may exist. If, for example, one’s spouse is closer in age to one’s children then oneself, there is the distinct possibility that the spouse survives the children, effectively removing them from the line of inheritance. While grandchildren may reap those benefits, this may not be consistent with the testator’s intent.
Even where the spouse is not close in age to the testator’s children, there are other emotional, familial and financial issues to consider. Marital Trusts, by definition, economically bind the surviving spouse to his or her step-children. The parties may enjoy a superb familial relationship, or they may not. But once the “glue” that holds these parties together has died, the relationship may become a purely economic one.
And whether the parties acknowledge it or not, the economic relationship is adverse. Every dollar that step-parent spends from the Marital Trust will one day result in the children receiving one less dollar (or perhaps even less when one considers the opportunity cost of compounding interest). Whoever the trustee is has a difficult job of balancing investments inside of a Marital Trust. The surviving spouse wants to maximize income while the children call for growth. Difficult decisions confront the trustee when considering whether to distribute additional amounts that the surviving spouse may request when home repairs, new cars or other major expenses loom.
IRAs, 401(k)s, pensions and profit sharing plans (I’ll just blanket all of these types of accounts by calling them IRAs) pose an even greater challenge. Naming a Marital Trust as the beneficiary to IRA accounts may only serve to result in higher income tax costs since the Required Minimum Distributions will eventually exhaust the account over time if the surviving spouse lives long enough. The alternative is to simply name the surviving spouse as the primary beneficiary.
But when the surviving spouse is named as the primary beneficiary, he or she can roll over the IRA into their own IRA. Now the surviving spouse has the ability to name whomever they want as their beneficiary. There is no guarantee that the children of the first deceased spouse will inherit anything from the IRA account at the surviving spouse’s death.
When IRA accounts are a significant portion of one’s estate, one may consider an annuity as an alternative. Annuities, by definition, are “wasting assets” in that their distributions consist not only of earnings (interest and dividends) but of return of capital (principal). As such, the “income stream” distributed by annuities tend to be higher than simply income that may be earned on investments.
Depending upon the situation, one might be able to divide up one’s IRA account into separate accounts to take care of a surviving spouse and children immediately upon death. In other words, one portion may include an annuity inside of the IRA that guarantees an income stream to the surviving spouse. All parties know and recognize that this portion of the IRA will likely be fully consumed and not end up with the children. The advantage to an annuity over simply bequeathing investment assets is that the annuity company guarantees the payout over the surviving spouse’s lifetime, no matter how long he or she lives.
The balance of the divided IRA account can name the children as direct beneficiaries. Using this approach, the children don’t have to wait until their step-parent’s death before receiving at least a portion of their inheritance. The surviving spouse/step-parent, on the other hand, has an income stream that won’t be scrutinized since the children would have no expectations of receiving any amounts from that portion of the estate.
There are many nuances to this approach that need to be carefully considered with legal, tax and financial counsel. Nevertheless, the thought of “unbinding” a surviving spouse to his or her step-children is worth considering, and may result in better familial relationships into the future since the parties are not tied to one another economically as they otherwise would have been.
©2014 Craig R. Hersch