You hear it all the time: 'Tax law is too complicated.' Well, it is. My job is usually to explain complex tax law in understandable language and to beat up the IRS-legally, of course.
Recently, a man I'll call Joe asked me to give him a second opinion on his estate plan. Unwittingly, he and his professional advisors had fallen into an expensive tax trap.
Here's his story: Joe (age 66) was married to his second wife Mary (age 52). Joe had three kids from his first marriage. The size of his estate clearly put him in the 55% estate tax bracket. Joe had two main goals: he wanted to leave his business (worth about $3.1 million) to his heirs and roll over $800,000 from his business' profit-sharing plan into an IRA. He had accumulated about $3 million in additional assets-mostly liquid-type investments, including a $500,000 home. His intent was to use this $3 million to pay the estate tax. Joe has no insurance but is insurable; so is Mary.
Federal estate tax laws allow an unlimited marital deduction for assets left to one's spouse. Generally, for property left in trust to your spouse to qualify for the marital deduction, your spouse must be granted unlimited access (meaning that your spouse gets not only the income but the principal as well, if needed to maintain the spouse's life-style) to the trust property during his or her lifetime.
A wonderful exception called a 'Q-Tip trust' allows you to do this delightful tax trick: You leave property in the Q-Tip trust, which requires your spouse to get all the trust income for life, and when your spouse dies, the property goes to your kids. This is a terrific tax-planning tool for second-marriage situations. Joe had set up a Q-Tip trust.
Now the trap. Joe made the Q-Tip trust the beneficiary of his IRA. When a beneficiary (in this case, Mary) becomes eligible to receive distributions from a qualified plan or IRA (usually at age 59 1/2), the annual distribution determined from the plan is based on the value of the plan at that time and on the life expectancy of the beneficiary. The annual distribution could be less than the annual income generated by the assets in the IRA.
Consider this example: If the $800,000 in Joe's IRA is invested at 6 percent, it will earn $48,000 each year. If Mary elected payment from the IRA over 20 years, the annual payout to the trust would be only $40,000. The result: disaster. Since the entire income from the IRA is not being paid to Mary, the IRA is disqualified as an appropriate asset for the Q-Tip trust. The result does not change even if the annual payout from the IRA happens to be greater than the annual income of the trust.
Now here's the disaster. Joe would have blown the marital deduction. The estate tax would be $440,000 (55% times $800,000). Withdrawal of funds from the IRA to pay this unexpected estate tax liability would be subject to income tax.
Very complicated stuff. But the fact is that we have learned how to beat the estate tax. Best of all, it's easy to do.
In this case, we created two irrevocable Life insurance trusts (we call them super trusts). One was funded with a policy on Joe's life; the other with a second-to-die policy (on Joe and Mary). We used Joe's liquid assets and the funds in the IRA to pay the premiums. This second-opinion estate tax plan eliminated the Q-Tip tax trap. Better yet, it eliminated the entire estate tax liability by transferring it to the insurance carrier.