Providing for Children of a Previous Marriage
by NCA Financial Planners on Jun 18, 2019
What is the purpose of providing for children of a previous marriage?
If you are married, most of your assets will typically pass to your spouse when you die unless you specify otherwise. Your spouse then owns most of the family assets. If you have made other provisions, you may have granted your spouse sole responsibility for deciding what happens to these assets when he or she dies. In the traditional family, this is rarely a concern--the family assets typically pass from the parents to the children. But, more and more often, the so-called traditional family is the exception, not the rule.
Remarriage can create numerous estate planning concerns, especially when you need to provide for both your current spouse and your children from a previous marriage. In many cases, remarriage creates a situation of "yours, mine, and ours." In other words, you or your current spouse may have children from a previous marriage and the two of you may decide to have a family of your own. If you remarry late in life, your spouse may not develop a stepparent relationship with the children from your previous marriage and may feel very little responsibility toward them. When you die, things could get extremely complicated. If this is the case, you need to take positive steps now to ensure that your estate is distributed according to your wishes.
Tip: Since statistically wives outlive their husbands, we will use the pronouns "she" and "her" in referring to the surviving spouse throughout this discussion.
Why the logical solution is typically the worst solution
You might believe there's an easy way to provide for both your surviving spouse and the children from your previous marriage. You'll let your spouse live in your home rent-free and live off the income from your investments for the rest of her life. Then, when she dies, the family assets will pass to your children from your previous marriage. That should make everyone happy, right? Wrong. In most cases, this plan will make everyone miserable and in fact can be a source of endless conflict between your surviving spouse and your children.
Your children's investment objectives won't match your spouse's
If your spouse is supported by the income from your investments, she'll want those investments to earn as much as possible. Thus, investment decisions will likely be geared toward high-yielding income investments. However, your children will want to see growth of principal so that their eventual inheritance will not be depleted by inflation or other factors. Neither party is probably willing to compromise.
Your children will be watching every penny your spouse spends
Your children know that the size of their inheritance is directly affected by how much your spouse spends during her lifetime. Thus your spouse may be having her every move scrutinized. If she buys a new car, your children may demand to know why she's squandering their inheritance.
Your children will effectively be waiting for your spouse to die
In many cases, there is a substantial age difference between the spouses in a second or third marriage. Your children may have a long wait if they will not receive their inheritance until your surviving spouse dies. They could easily be elderly before your assets are transferred to them.
What you can do
There are many steps you can take to avoid such undesirable situations. Some are simple, while others are more complex. In most cases, you will require the help of an attorney or estate planning professional.
Most importantly, eliminate the money connection
Rather than making your children's inheritance contingent on your spouse's death or effectively giving one party control over the financial affairs of the other, consider eliminating the economic connection between your surviving spouse and your children. A plan where your children's inheritance is not dependent on your spouse's actions (or vice versa) is bound to be more satisfactory to all involved.
Use life insurance
Life insurance can be a particularly effective method of providing for children from a previous marriage. You have several options when considering the use of life insurance for this purpose. You can make your children beneficiaries of a life insurance policy that you own. Or your children can purchase insurance policies on your life and you can make a gift to them of the money to pay the premiums. Or you can establish an irrevocable trust to hold life insurance purchased for their benefit. This third option is especially appropriate if you have minor children. In any case, your children are the beneficiaries of the life insurance policy, and you are guaranteed they will receive a certain amount of money when you die. And if properly structured, life insurance proceeds go directly to the beneficiary and may be able to avoid being diminished by estate taxes.
Name your children as beneficiaries on your retirement plan
Making your children the beneficiaries of your IRA or qualified retirement plan is another way to provide for their needs after your death. You may need your spouse's written consent if you wish to name anyone other than your spouse as the beneficiary of your certain retirement plans. Even when you have this consent, however, your problems still may not be solved. The distribution rules for nonspouse beneficiaries can be extremely complex.
Tip: Income from your retirement plan will typically be taxable to the beneficiary.
Create a prenuptial agreement
Prenuptial agreements are not for everyone, but they can help eliminate conflicts between your prospective surviving spouse and your children from a previous marriage. A prenuptial agreement is a written contract between prospective spouses that states how assets will be owned and distributed during the marriage, in the event of divorce, and at death. Both parties' financial rights and responsibilities are enumerated, and the contract can only be altered or broken with the consent of both parties.
Make your children joint owners
Giving your children joint ownership of specific assets during your life will ensure that they receive those assets upon your death. However, there are significant risks associated with this strategy. For one thing, there could be significant gift tax consequences. Moreover, as joint owners, children typically have unlimited access to the assets, meaning they might have the right to sell the assets and use the proceeds for their own benefit. The assets could be in jeopardy from your child's creditors if your child runs into financial difficulty or gets a divorce.
Leave your surviving spouse a lump sum
Consider leaving your surviving spouse a lump sum and dividing the remainder of your assets between your children. Or leave each of your children a lump sum and have the remainder pass to your surviving spouse. While this seems like a simple approach, there are instances when it can be very effective, especially if you have a small estate and few assets.
Tip: If you choose this option, make sure you have an accurate estimate of your estate tax liability and other expenses. Otherwise, the remainder of your assets will be less than you anticipate.
Qualified terminable interest property (QTIP) trust
A qualified terminable interest property (QTIP) trust is a marital trust typically used in conjunction with a bypass trust to provide for children of a previous marriage or other beneficiaries. When you die, your spouse receives the income from the assets in the trust for the rest of her life. However, she will not have the right to take the assets out of the trust, nor does she have the power to designate who receives the assets when she dies. You designate the ultimate beneficiary of the trust when it is created.
Caution: In many cases, this will not be a desirable option because it does not eliminate the money connection between your surviving spouse and your children. However, if you're certain that a financial relationship between your spouse and children will not cause problems, a QTIP trust might be a viable option.
What you can't do
Disinherit your surviving spouse
In almost every state, you are prohibited from totally disinheriting your surviving spouse. Surviving spouses are typically given a statutory right of election that allows them to claim a certain percentage of the deceased spouse's estate. Many states grant surviving spouses the right to one-third of the deceased spouse's estate, while some allow the surviving spouse to claim one-half. If the surviving spouse receives less than his or her statutory share of the estate in the decedent's will, the statutory right of election can be invoked to make up the shortfall. To claim the right of election, the surviving spouse must initiate legal proceedings. The local probate or surrogate court will then order the beneficiaries or the personal representative of the estate to contribute a prorated share of the estate's assets to satisfy the surviving spouse's right of election.
Tip: In some states, the spouse's right of election extends only to assets that pass through probate. In addition, some states have adopted a scaled right of election in which the percentage the spouse can claim depends on the length of the marriage.