Plan ahead to protect all of the people you love.
You're at the annual family reunion and you notice that less than half the people there are related to each other—some are your husband's children from a previous marriage, or they're your children from a previous marriage. As for the parents at the reunion, they've remarried too. Your father passed away several years ago, and your mother recently remarried. As a result, your four new stepsiblings are in attendance as well.
If this sounds like your family, welcome to the new form of family life. Blended families now outnumber traditional families, according to the U.S. Census Bureau. Rising divorce rates aren't the only reason—our longer life spans mean that many more people are outliving their spouse and remarrying.
A blended family can make estate planning more complicated. For example, you may want to leave different inheritances to biological children than you would to stepchildren, or to protect your biological family's inheritance in the event your spouse remarries.
A solid estate plan can help you prepare for these or other scenarios. "With so many kinds of blended families, it makes sense to put in place a plan that directs your assets to the people you choose, rather than possibly to someone you don’t know or don't necessarily want as a recipient," says Michael Christy, regional manager, Fidelity Wealth Planning and Personal Trust.
Blended families without an estate plan may run the risk of scenarios like the following:
An ex-wife inherits her former husband’s bank accounts, home, or retirement assets, even though her former husband had willed them to his children.
One child inherits the family home, even though the home was promised to another child.
A husband dies before his new wife and leaves his estate to her; when she dies, she leaves the assets to her children, not to his.
As you sit down with your financial and estate planning advisers, consider:
Beneficiary designations play a critical role in estate planning. They are even more important in blended families. A divorced individual may eventually remarry and/or have additional children. Given that scenario, the individual should consider updating beneficiary designations on any policies and accounts in light of his or her new family. This is critical: Beneficiary designations will override a will if the documentation isn't consistent. "It doesn't matter if the language in your will says otherwise," says Christy. "Your ex-spouse will receive the assets if he or she is still named as beneficiary in the legal documentation supporting the policies and accounts."
Also, the newly remarried individual should consider updating his or her will so it reinforces the beneficiary designations and plans for other assets, including property and family heirlooms. The will should also be updated to reflect the correct fiduciaries.
A revocable living trust is a trust organized and funded while the owner of the assets is still alive, and the person who establishes the trust (sometimes referred to as the "grantor," "settlor," or "trustor") typically maintains complete access to and control over the trust assets. These kinds of trusts, if set up properly and valid under state law, provide the grantor with the opportunity to direct who receives the assets—both before and after the grantor’s death. During the grantor’s lifetime, the trust can be amended, changed, or terminated, and the grantor can even take withdrawals and receive income from them. After death, the trust can help the family avoid the costs, delays, and headaches of probate.
A grantor can even spell out how the trust's assets are shared and spent:
Per stirpes language distributes the assets equally to each branch of a family. For example, if a child predeceases the grantor, per stirpes language is intended to ensure that the deceased child’s children share equally in the assets the grantor intended for the deceased child.
A "spendthrift" provision can protect a beneficiary’s share from wasteful and unwise spending. A grantor could even name an independent trustee to control the funds on behalf of the child. If properly drafted, the assets are off limits to the beneficiary's creditors, including any future ex-spouse of the beneficiary.
"Discretionary distribution" language may direct the assets even more specifically. Common examples include earmarking trust proceeds to cover health care expenses, helping to maintain a beneficiary’s standard of living, purchasing a home, establishing a business, or paying for an education.
Marital trusts and QTIPs
Marital trusts are created to take advantage of the federal tax laws that exclude inheritances between spouses from estate tax. They generally are not effective until the first spouse passes away, at which point the trust is funded with the assets the grantor has identified for this purpose. Generally, the purpose of a qualified terminable interest property trust, or QTIP, for the marital trust is to provide income and, potentially, principal, if necessary, for a surviving spouse while preserving the underlying assets of the trust for the grantor's children or other designated beneficiaries. If the trust is structured such that the surviving spouse has at least a lifetime income interest in the QTIP, the grantor's funding of the trust qualifies for the unlimited marital deduction, which means than an unlimited amount may be transferred to the QTIP without federal estate or gift taxes being incurred on the transfer. QTIPs can be an especially helpful strategy for blended families (for example, to provide income for a second spouse of the grantor for life, while helping to ensure that the grantor's children from a first marriage will receive an inheritance upon the second spouse's passing).
Irrevocable life insurance trust
An irrevocable life insurance trust, or ILIT, can be used to allow the death benefit from a life insurance policy to pass outside the grantor's estate and therefore can shield the life insurance proceeds from federal estate taxes. Typically, the grantor places money in the trust, and a trustee uses the funds to purchase an insurance policy on the grantor’s life. Because the grantor does not own the policy and the trust does, the insurance policy can be excluded from the grantor's estate. That way, the full value of the policy can go on to benefit survivors rather than a portion of it being paid in estate taxes.
Parents in blended families may choose to make their children the beneficiaries of the life insurance trust, while leaving assets outside the ILIT to the surviving spouse. This strategy can be especially useful when one spouse is older and has considerable assets. "An ILIT can sometimes be a good way to leave a specific inheritance amount to children, potentially free of federal estate taxes, whether the proceeds of the policy remain in trust or are distributed outright when the insured passes away," Christy says.
An ILIT has another benefit: It can provide the liquidity a family may need to cover taxes on an estate. This advantage is especially helpful if the estate consists largely of relatively illiquid assets, such as retirement accounts, real estate, or a business.
Bear in mind that the first "I" in ILIT stands for "irrevocable." Assets placed in an irrevocable trust are no longer available to the grantor, regardless of need. Also be sure to discuss with your tax professional or attorney any potential gift-tax implications related to funding the trust, both initially and on an ongoing basis, as may be necessary to support the trust's payment of life insurance premiums. For example, there are annual federal gift-tax exemption amounts and lifetime gift-tax exemption amounts that must be adhered to in order to avoid the application of federal gift taxes to the grantor's transfer of assets to the trust.
A "no-contest clause," also known as an in terrorem clause, specifies that if a child or spouse or any beneficiary challenges the beneficiary designations under a trust or will, that person forfeits his or her share of the estate. In other words, the grantor can remain confident that his or her wishes will be honored. Please note that the laws of some states prohibit or restrict the enforceability of these clauses.
Trusts are increasing in popularity, as families transform from nuclear families to extended and blended families. Not only can trusts be used to help reduce the potential impact of estate taxes, they can also help grantors designate which family members control their legacy in the future.
Keep in mind that estate planning is a complex area, with significant tax, legal, and economic implications, and that the estate planning vehicles and tactics mentioned in this article are only a representative subset of those available. Before taking any action, consult your attorney or tax adviser regarding your specific situation.
"Every parent hopes that all their children get along. But the combination of death and money stirs up powerful emotions, which can get the best of them," Christy says. "You can help protect your legacy and your heirs by taking control of your estate planning now."
A prenuptial agreement can be a good way for parents who are remarrying to specify which of their assets they’d like to earmark for their children. For example, a prenuptial agreement can help couples designate college savings they each have put aside for the children from their first marriage. A postnuptial agreement, signed after the couple has taken their vows, is less common but could work the same way. Please note that in some states, prenuptial agreements, as well as postnuptial agreements, are not valid, and a judge could ignore or invalidate the agreement.
Impact of divorce
Following a divorce, the former spouses should review the ownership of all their accounts, including bank and brokerage accounts, as well as property and assets, such as real estate, vehicles, and insurance. Depending on the terms of a divorce judgment, accounts may need to be reregistered or even closed, and record ownership of other assets held may need to be modified. It is equally important for the former spouses to review their respective estate plans to make sure the plans reflect any terms of the divorce judgment, and all other changes that should be made following the divorce.
For example, a newly divorced couple may want to update their wills and, as discussed above, consider updating all the beneficiary designations on accounts and policies that name the former spouse as the beneficiary. These can include life insurance policies, annuities, bank and brokerage accounts, IRAs, and workplace retirement plans. Please note that some divorce agreements prohibit such actions. Consult your legal counsel concerning your particular situation.