Your Kids, Your Will And Your Second Spouse

You never know how truly complicated life can be until you marry, have children, divorce, and remarry--and accumulate enough wealth to start worrying about where all the money will go that you can't take with you. That's when you suddenly develop an interest in estate planning.

Like it or not, after your death your spouse may not feel the same compulsion to provide for your kids that he or she did when you were alive. The goal of estate planners is to find a way to take care of the spouse and leave an appropriate amount to the children of the previous marriage--while paying as little in taxes as possible.

How to do this becomes more intricate the larger the estate, the bigger the age gap between husband and wife, and the more children from different marriages there are to consider. "People in these situations come to the table with a lot of emotional baggage," says Joel Isaacson, a New York financial planner. "You have to raise issues and discuss problems no matter how difficult it may be."

SPREAD AROUND. Consider this scenario: Your second husband--who had no children of his own--loves your five kids from your first marriage and intends to make them the chief beneficiaries in his will. But by the time he dies, 20 years after you do, only $50,000 of the $2 million you left to him remains to spread around. Or picture this: Not long after your death, your second wife remarries. Instead of leaving what she inherited from you to your children, as she promised, she decides her second husband and the children they've had together deserve it more.

Luckily, estate planners have devised strategies that can ward off such disasters. A few techniques are specifically meant for what they term "second-marriage situations." Others are simply tools they always have in their bag but that can be applied to help balance out the competing interests in your estate. These plans, and the attorneys who draft them, don't come cheap. The documents alone can run $3,000 to $6,000, while planning services can cost $5,000 to $10,000, depending on the size and complexity of your estate.

Unless you have an estate of more than $1.2 million (the amount you can easily shield from inheritance taxes), you need not worry about esoteric planning tools. But even people with a few hundred thousand dollars may want to use trusts to provide income for their spouse and preserve the principal for their children after the spouse dies.

The easiest way to do this is through a "credit shelter trust," which is also known as a "bypass" or an "A" trust. The maximum you can put into this kind of trust is $600,000--the amount you can leave to anyone exempt from inheritance taxes. These are very flexible instruments, but typically, someone with a small estate in a second marriage would structure the trust to provide an income for a spouse, then have the principal go to the kids after the surviving spouse's death.

You could also choose to have half the income paid to your children and half to your spouse, or have all the income go to your children. However, if your children are old enough, and you don't intend to include your spouse in the credit-shelter trust, you could leave your kids the $600,000 outright and forego the limits of trust arrangements. Another option is to give an independent trustee discretion over disbursing the income, by including "sprinkling" (also known as "spray") powers. That way, if your spouse needed the money more than your children did, he or she would have access to it.

With estates of several million, the $600,000 you can place in a credit-shelter trust is probably too small a sum for your children to receive their fair share, says Dawson Taylor, a partner at Cairncross & Hempelmann, a Seattle law firm. That's where Qualified Terminable Interest Property Trusts, or QTIPs, come in.

NO CONTROL. Far less flexible than a credit-shelter trust, a QTIP can be as large as you want, but it must be structured so that your spouse receives all the interest for life and has no control over who gets the money after death. But because the surviving spouse gets all the income, no tax is due on the trust until after he or she dies and the proceeds pass to your children. A division of a $2 million estate could include giving the children $600,000 in a credit-shelter trust, leaving the spouse $400,000 outright, and putting $1 million in a QTIP, says Isaacson.

QTIPs prove the most inadequate when the surviving spouse is close in age to the children from the first marriage. Consider this hypothetical estate: A 65-year-old man has $10 million to distribute among his 45-year-old wife and three children in their 20s and 30s from a previous marriage. To avoid estate taxes, he could leave $9.4 million in a QTIP and give his children $600,000 outright. "In all likelihood, the children won't get any money from the QTIP until they're in their 60s, so he is effectively disinheriting them in favor of his grandchildren," says Joseph Toce Jr., head of family-wealth planning at Arthur Andersen.

If he wanted to split the estate half and half, he could instead leave $5 million in the QTIP and hand $600,000 tax-free plus a taxable $4.4 million to his children. The problem is that about $2 million of the estate would go to pay inheritance taxes at his death. Federal estate taxes start at 37% for estates valued at $600,000 to $750,000 and reach 55% for estates larger than $3 million. Not surprisingly, estate planners have ways to minimize the tax bite.

The best option is to make use of gift-tax exclusions. If your spouse will participate, you can distribute $1.2 million among your children tax-free during your lifetime (but you will no longer be entitled to the $600,000 exclusion at your death). Then, annually, you can also give each child an additional $20,000 (or $10,000 if your spouse doesn't join in) exempt from taxes.

If you can't provide your children with the portion of your estate they deserve tax-free through gifting, you can use life insurance. Properly structured, an irrevocable life-insurance trust is not subject to estate or income tax. These trusts are often used to provide heirs with cash to cover estate taxes on a business or expensive home they have inherited. But life-insurance trusts can also be useful in second-marriage situations to provide an inheritance directly to your children.

Here's how it works: You irrevocably transfer your insurance policies into a trust so they are not considered part of your taxable estate. The trust is named the beneficiary, and it pays out the proceeds after your death. These trusts can also grant a trustee sprinkling powers. The premiums are paid by gifts you make to the trust.

A charitable lead trust can be another useful tool. The trust pays an annuity to a charity for several years and then the principal reverts to your children, who get a discount on the estate taxes based on how much the charity received. That way, your kids know when they will get their inheritance.

Much of the anxiety that second marriages arouse can be alleviated through a prenuptial agreement, says Stuart Kessler, senior tax partner at Goldstein Golub Kessler & Co. He says he has lost clients who were offended when he suggested a prenup, but he believes they are necessary when there are children from a previous marriage. For one thing, if the amount you intend to give your kids will prevent you from leaving your spouse the percentage of your estate required by state law, a prenup signals that your new spouse will waive his or her rights. And it should put your children's fears to rest--which may make for a friendlier, more trusting family relationship while everyone is still alive.

      PRENUPTIAL      Helps resolve any family tension about how a second
      AGREEMENT       marriage will affect your children's inheritance. Some
                      states set a minimum on the percentage of an estate a spouse
                      must inherit. The prenup can often get around it.
      CREDIT SHELTER  A trust formed with the $600,000 that is exempt from
      TRUST           estate tax. In a second marriage situation, the trust
                      (also called A Trust provides income to the surviving spouse
                      for life, but after or Bypass Trust) his or her death, the
                      principal goes to the children.
      QTIP TRUST      Similiar to the above credit shelter trust, but for those
                      with estates larger than $600,000. Proceeds are taxed after
                      the second spouse's death.
      GIFTING         By dividing the $600,000 ($1.2 million if your spouse
                      PROGRAM participates) exemption among your children, plus
                      giving them each $10,000 a year ($20,000 with your spouse),
                      you may be able to provide your children with much of their
                      inheritance tax-free, before you die.
      IRREVOCABLE     Properly structured, these trusts are free from estate and
      LIFE INSURANCE  income taxes. Transfer your policy to the trust and gift
      TRUST           the premiums. The trust receives the death benefit, which is
                      disbursed immediately or managed for your heirs.
      TRUST WITH      Grants a trustee discretion over the distribution
      OR              income from a trust. Income can go to the surviving
       POWERS         spouse or your children, according to their needs.
       CHARITABLE     The trust pays income to a charity for a set number of
      LEAD TRUST      years before your children inherit the principal. They
                      then get a discount on estate taxes based on the amount the
                      charity received. Another plus: Your children know what year
                      they'll receive their inheritance.
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