Putting Incentive in Your Estate Plan
For many affluent individuals, estate planning extends well beyond mere
tax planning and involves very personal decisions regarding the distribution
of future wealth. In more traditional estate plans, the so-called spendthrift
trust is used as a mechanism for distributing trust income, while limiting immediate access to trust principal. True, a spendthrift trust can provide financial security and stability for minor children, as well as protect adult heirs from some creditors and personal failures in judgment.
However, such trusts provide heirs with little incentive to expand their own
professional, academic, or philanthropic horizons. Thus, affluent individuals who
are particularly sensitive to the potential ramifications of “handing over” considerable wealth to heirs may find comfort in adopting an incentive-based estate plan. One of the cornerstones of an incentive-based estate plan is a trust with incentive provisions. Like other trusts associated with estate planning, a trust with incentive provisions serves as an outline that guides trustees in the implementation of an affluent grantor’s expectations regarding the future uses of his or her estate. Similarly, an incentive-oriented trust can help ensure proper care and financial support if an heir falls on hard times or has special needs. However, this type of trust is somewhat unique in that the general distribution of trust income is rooted in a series of predetermined “incentives.”
What is “The Incentive”?
The incentives outlined in a trust are virtually up to the imagination of the grantor so long as the incentives do not violate public policy. Each incentive
provides the grantor with the ability to encourage specific, future behavior.
For instance, the trust could have provisions that pay each heir $10,000 upon the receipt of a bachelors degree, $25,000 for a masters degree, and $50,000 for a doctorate. A trust with incentive provisions can also be an ideal mechanism to reward family members who pursue and/or distinguish themselves in potentially
less lucrative careers, such as music, the arts, research, or teaching. Or, it can
reward younger heirs for academic success or community involvement.
In addition, the trust could match certain levels of income for heirs who are less than a specified age (e.g., 35). A trust with incentive provisions can also be an excellent
education funding resource. Unlike a custodial account, which generally becomes the property of the child once he or she attains the age of 18, a trust can dictate that some trust assets be utilized to fund education costs. Thus, the trust, rather than a young,
inexperienced adult, can maintain control of monies earmarked for education. Another interesting use of incentives in a trust can be to allow trust principal to act as a “family bank.”
The trust can offer low interest rate loans for startup business ventures or the purchase of a primary residence. A lending process similar to that of a traditional lending institution
can be required to ensure minimal risk to the trust. For instance, an heir who is seeking capital financing from his or her trust may need to present a business plan that must be
reviewed and approved by an objective third party.
Philanthropy creates another intriguing possibility for an incentive-based estate plan. Certainly, many affluent individuals consider philanthropic pursuits very important
endeavors. A trust can be used to match the charitable contributions of a beneficiary. If so desired, the trust’s matching contribution can be arranged as a distribution to the beneficiary, which is then contributed to the charity. The distribution may be taxable
depending upon whether it is a distribution, or income, or principal. The beneficiary
can reap the benefits of a charitable deduction on both his or her own contribution, as well as the trust’s matching contribution. Similarly, any remaining trust income that has
not been distributed through incentives may make for an ideal contribution to a family foundation or charity. Such contributions also can be arranged so they are made on behalf
of trust beneficiaries.
Often, the grantor may wish to attain a greater degree of control over the trust’s charitable contributions. In such cases, the grantor can establish a foundation or charity that will receive the trust’s charitable contributions. As an added benefit, heirs can be reasonably compensated for their management and/or active participation in the charitable organization. Thus, charitable intention truly can become a cornerstone of the grantor’s
Finally, a trust with incentive provisions may provide some degree of insulation from creditors; although, it should not be considered an asset protection device. While it may be possible to incorporate some language in the trust that discourages certain attacks by creditors, other estate planning mechanisms are much more appropriate for achieving
asset protection goals.
Instilling Family Culture
Often, the effects of inherited wealth can have a negative impact on the motivation of heirs. For instance, when some heirs receive a substantial inheritance, they may be
content with a lifestyle of leisure rather than one that pursues excellence and productivity. Thus, the reasoning behind incentive based estate planning is fairly straightforward. Assets and income are distributed to assist heirs who are realizing career or academic goals, and/or whose actions are consistent with the expectation of an affluent grantor. By
adopting some of the principles of incentive based estate planning, the affluent grantor can create an environment that promotes a family culture of hard work and effort for
generations to come. $
A Quick Look at Employer-Sponsored
When each year draws to a close, it brings the realization that upon us, and tax matters begin to gain increased attention. Generally, tax planning is most effective when begun early in the year, and you may be able to lower your tax bills
through judicious use of employer sponsored reimbursement accounts. These plans, which provide for certain benefits using pre-tax dollars, are defined under IRS Code Sec. 125, and are commonly referred to as cafeteria plans—or simply, Section 125 plans. The two most common benefits covered in reimbursement
accounts are medical and dependent care expenses.
What Can I Claim?
Many taxpayers find they cannot claim an itemized deduction for medical expenses because, to do so, their medical expenses must surpass 7.5% of their adjusted gross income (AGI). For most, the 7.5% “floor” probably amounts to
several thousand dollars, and it is generally unusual to have that much in
medical bills unreimbursed by insurance.
Contributions to a “medical reimbursement account” are made before federal income taxes or Social Security (FICA) taxes are withheld and, in most areas, before state and local taxes are deducted, as well. While it is tax free, it remains
the account holder’s money to use for specified unreimbursed medical bills,
including prescription drugs. The net effect is a tax-advantaged mechanism for funding qualified medical expenses that would probably not otherwise be
deductible. There is one catch: If, during the year, all of the contributions into
the account are not spent, any remaining balance is forfeited.
There is a similar reimbursement account arrangement for child or adult dependent care expenses. An employer withholds pay—which again is not counted as taxable income—and puts it into a special account. The account can then be used to reimburse expenses, within certain limits, for care needed for dependents while the account holder and his or her spouse go to work or, in some cases, to school. So that no double benefit is obtained, the expenses that are reimbursed from the dependent care account cannot be used in calculating the child and dependent care credit on your income tax return.
These medical and dependent care reimbursement arrangements have to be set up by the employer. Once the year begins, contributions generally cannot be rolled, increased, or discontinued unless there is a change in employment or family status, such as a marriage, divorce, or birth. (Employers also save because the contributions are exempt from the employer’s share of Federal Insurance Contributions Act (FICA) taxes on regular wages.) If you anticipate an unused surplus, you may be able to schedule some covered services before the end of the year. Employer-sponsored reimbursement accounts provide a great opportunity to help reduce your taxable income and maximize important benefits. A little planning now may go a long way toward easing your tax burden.
The ABCs of QDROs
It is rarely pleasant to discuss divorce, yet it is an unfortunate occurrence
that happens with increasing frequency in our society. Because divorce involves the division of assets, which have tax implications, it is important to be aware of
the “tax traps” that may be lurking. One such trap exists in the area of retirement
plan assets because of the existence of vested account balances. In the past, with traditional defined benefit plans, the plan participant was promised a retirement benefit, but had no vested retirement account balance. However, with the recent shift toward defined contribution plans, vesting for employee contributions is
immediate, and vesting for employer contributions builds quickly. Consequently,
as more Americans participate in 401(k) plans and other defined contribution
retirement plans, dividing vested retirement plan assets in divorce situations has createdcomplex financial issues.
A Closer Look
A QDRO is a judgment or order that relates to child support, alimony, or property rights pertaining to a spouse, former spouse, child, or other dependent. A QDRO can be used to establish one spouse’s right to part or all of the other spouse’s
retirement plan(s)—and ensures the recipient spouse pays the tax.
To be protected through a QDRO, it must specify:_ The name and address of the plan participant and the “alternate payee” (typically, the participant’s spouse).
The name and account number of each retirementaccount involved. The percentage (or dollar amount) of each plan that is to be paid to the alternate payee. The period of time, or the number of payments, covered by the QDRO.
The QDRO must go in the divorce decree or court-approved property settlement document. The decree should also specify that a QDRO is being established under Section 414(p) of the Internal Revenue Code (IRC) and the particular state’s domestic relations laws. Intent to establish a QDRO is insufficient; it must be
spelled out in the divorce papers.
Getting divorced can be “taxing” enough, but it need not be made more difficult by mishandling the division of assets in a retirement plan. Applying the proper language in a divorce decree may ease some of the inevitable complications that can arise and aid in a smoother transition for all involved. At a minimum, qualified legal advice should be obtained to ensure that any desired planning actions are properly worded and structured.