Disclaimer Dilemma

     Qualified Retirement Plans (QRPs) comprise a significant share of the estate value for many Americans. This remains true despite the inevitable ups and downs of the stock market. One reason QRPs weather economic storms better than non-qualified investments is their unique tax treatment.
     All contributions to QRPs are made with pre-tax dollars and all of the growth inside such plans is tax-deferred until withdrawn. Hence, contributions to QRPs not only reduce your current income tax liability, but also grow with compound interest and without the reductions for annual income taxation.
     However, married couples in particular face unique tax challenges when selecting the Designated Beneficiary (DB) of their QRPs.

Death Tax Basics

Contrary to popular belief, QRP assets are included in the overall value of your estate for estate tax purposes. Under current tax law, every taxpayer has a $2 million Applicable Exemption Amount, which can be used to exempt assets from estate taxation. (This is an extremely valuable exemption because estate tax rates are progressive, and can exceed 45 percent.) Accordingly, a married couple may, with proper estate tax planning, use two of these exemptions to protect a total of $4 million in estate value.
     This double exemption, however, is not automatically applied and, without proper planning, a married couple may lose the full benefit of their combined $4 million protection to the unnecessary enrichment of the IRS.

Tax Trap

     How do married couples fail to maximize their federal estate tax protection? Consider the following case study.
     Husband and Wife have a combined estate value of $4 million. Wife has a $2 million QRP and Husband has $2 million in non-QRP assets. Wife selects Husband as the designated beneficiary of her QRP. When Wife dies, Husband inherits the QRP as an income-tax-deferred rollover. [Note: Only a surviving spouse may rollover an inherited QRP and continue to defer withdrawals until such spouse's own Required Beginning Date of April 1st of the calendar year after turning age 70^1/2.]
     Because of the Unlimited Marital Deduction there are no federal estate taxes due. But, this can be a tax trap. Any assets passing to a surviving spouse via the Unlimited Marital Deduction forfeit the Applicable Exemption Amount of the deceased spouse. Think of it as an unused, expired coupon. In our example, Husband now has the full $4 million in his estate. He can use only his own Applicable Exemption Amount "coupon," as his deceased wife's is no longer available. This may result in an avoidable federal estate (and income) tax liability.

Disclaimer CST

     Given the same basic facts as above, Wife could create a Credit Shelter Trust (CST).
     Under this approach, Wife would select Husband as the Primary Designated Beneficiary of her QRP and name the trust as Contingent.
     Upon Wife's death, Husband could disclaim the QRP, making the Credit Shelter Trust the designated beneficiary by default.
     Result: Wife's Applicable Exemption Amount would be applied to the value of her QRP (which Husband disclaimed to the trust). Husband can still have access to the QRP assets, however, as the trust beneficiary. The downside is that because the trust is not a surviving spouse, no rollover of Wife's QRP is permitted and income-taxable distributions must begin to Husband.
     While this technique may forfeit the income tax deferral available through the spousal rollover, it may achieve significant federal estate tax savings. Nevertheless, the Credit Shelter Trust Disclaimer alternative allows the surviving spouse to retain maximum flexibility over the couple's combined wealth and its ultimate disposition. Therefore, it is most appropriate in first marriages where any children are those of that marriage. Blended family situations, on the other hand, present unique planning challenges.