If you’re recently divorced, you’ve likely had your fill of legal documents and proceedings. But it’s important to review your estate plan as soon as possible to ensure you’re protected against unintended consequences. Consider the following questions after your divorce.
How can I keep control of my assets?
Generally, a divorce judgment automatically extinguishes your spouse’s rights under your will or any trusts. So there’s little danger that your ex-spouse will inherit your property, even if you haven’t yet amended your estate planning documents. If you have minor children, however, your plan may inadvertently give your ex-spouse control over your wealth.
Property inherited by minors generally must be held in a conservatorship until they reach the age of majority (usually 18). And in most cases a court will appoint their surviving parent (your ex-spouse) as conservator. Even though the conservatorship will be under court supervision, your ex-spouse will have a great deal of discretion in determining how your assets are invested and spent while the children are minors.
The best way to avoid this result is to create one or more trusts for the benefit of your children. A trust allows you to choose a trustee who’ll be responsible for managing assets and making distributions to your children. It also allows you to determine when and under what circumstances the children will receive your property. For example, you may want to delay distributions until your children are beyond the age of majority or have reached certain milestones (such as finishing college or finding a job).
Also, a trust can protect your children’s inheritance from claims of their ex-spouses. (See the sidebar “Divorce protection for your children.”)
What if I decide to remarry?
Estate planning is particularly important if you remarry. Suppose, for example, that you have children from a previous marriage. If you haven’t updated your will or trusts, a substantial portion of your estate may go to them (under your ex-spouse’s control, if they’re minors). This may not be the best result, particularly if your new spouse and any children of the second marriage need more financial support than children from the previous marriage.
It’s also important to consider estate taxes, although they aren’t as big a concern as they once were. Today, the federal estate tax exclusion is more than $5 million ($5.34 million in 2014), so relatively few families are subject to the tax. But if your estate is very large, there may be opportunities to reduce or defer estate taxes. Here’s an example:
Frank dies with a $15 million estate. He leaves $5 million to his second wife, Marie, and $10 million to his children (Ray and Debra) from his first marriage. The $5 million he leaves to Marie is shielded from tax by the marital deduction, but the $10 million he leaves to Ray and Debra triggers a $1,864,000 estate tax liability (assuming a 40% tax rate). Had Frank left his entire estate to Marie, estate taxes would have been deferred until her death.
The problem with this approach is that, by leaving everything to Marie, Frank puts his children’s inheritance at risk. What if Marie spends it all? What if she remarries and leaves everything to her new husband and children?
Here are two strategies Frank can use to provide for Ray and Debra while still taking advantage of the marital deduction:
1. QTIP trust. Generally, to receive the benefits of a marital deduction, you must leave property to your spouse outright. The qualified terminable interest property (QTIP) trust is an exception to this rule. A QTIP trust is an irrevocable trust that pays out all of its current income to the surviving spouse at least annually and meets certain other requirements. In the example, had Frank transferred assets to a QTIP trust, he could have taken advantage of the marital deduction while preserving the trust principal for Ray and Debra.
Historically, there was a disadvantage to leaving your entire estate to your spouse, either outright or in a QTIP trust: The marital deduction defers, but doesn’t eliminate, estate taxes, so the assets were eventually subject to estate tax as part of the surviving spouse’s estate, wasting the first spouse’s estate tax exemption. With the advent of portability, however — which allows a surviving spouse to take advantage of a deceased spouse’s unused exemption amount — this disadvantage has been eliminated in most cases, or at least minimized.
2. ILIT. Another option for Frank is to establish an irrevocable life insurance trust (ILIT) for the benefit of Ray and Debra. He can leave his entire estate to Marie, taking full advantage of the marital deduction, while also providing a generous inheritance for his children. If the ILIT is designed properly, the insurance proceeds will pass to Ray and Debra outside of Frank’s estate and be free of estate taxes.
Keep what’s yours
In the event of a divorce, ask your advisor to review your estate plan as soon as possible. The last thing you want is for your hard-earned wealth to end up in the hands of an ex-spouse or your child’s ex-spouse. Several strategies are available to make sure that won’t happen.
Sidebar: Divorce protection for your children
When people plan their estates, they often overlook the possibility that their children may get divorced. If that happens, there’s a risk that your child’s ex-spouse will end up with some of your property in a divorce settlement.
The most effective way to avoid this result is to establish a trust for your child’s benefit. But simply setting up a trust isn’t enough. You must design the trust carefully to ensure that your child’s ex-spouse has no claim to the trust assets. If the child has too much control over the trust, a court may view the trust assets as marital property subject to division in divorce.
It’s also advisable to avoid giving the child a remainder interest in the trust or providing for mandatory distributions, which may be considered property rights in some states. Ideally, to ensure that your child’s ex-spouse can’t reach the trust assets, give the trustee full discretionary authority over whether to make or withhold distributions.