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PREVENTING STEPCHILD SYNDROME

Almost half of all married couples end up divorced, according to the U.S. Census. But 75 percent of those people jump right back into marriage again. And while your clients would like to believe they got it right the second time around, remind them that The Brady Bunch was not reality TV. The transition is not always smooth for children from the first marriage to life with the new spouse. In some

Almost half of all married couples end up divorced, according to the U.S. Census. But 75 percent of those people jump right back into marriage again. And while your clients would like to believe they got it right the second time around, remind them that “The Brady Bunch” was not reality TV. The transition is not always smooth for children from the first marriage to life with the new spouse. In some instances, the new spouse cannot be trusted to give the kids their proper share of the estate after your client's death.

So while the emotional issues surrounding divorce and remarriage are tough, the financial concerns can be just as complex. Your client may feel overwhelmed by the abundance of things he needs to do to ensure his loved ones are properly cared for after his death. As his advisor, he'll be looking to you to make sure the details are covered.

To start, redo his will and help him change all the beneficiary selections on IRAs, 401(k)s, life insurance policies or any other asset that requires a beneficiary, assuming he no longer wants to leave it all to his ex-spouse. “So many people are forgetting to do this,” says Carlyn McCaffrey, a partner in New York law firm Weil, Gotshal & Manges and co-author of Structuring the Tax Consequences of Marriage and Divorce. So stay on top of this for them. And don't forget to change the executor on his power of attorney and living will.

Split the Property

It is important that your client fully understand the value of his assets. To start, he will need to determine which assets were acquired during the marriage and which were from his single days. Any assets acquired before the marriage remain his. But all assets purchased during the marriage must be shared.

That generally includes most pensions and retirement accounts, such as 401(k)s. Splitting those can get ugly, since they are valued as if employee were to leave today. In most instances, the unemployed spouse is entitled to half. But liquidating a retirement plan before age 59 1/2 can mean big taxes and penalties. So make sure that is considered at the bargaining table.

The good news is that the transfer of stocks, bonds, houses or any other tangible property at the time of the divorce is not a taxable event. The assets' original basis and holding period also are transferred. So, if one spouse gets the house while the other gets the stock portfolio, there's no tax until the assets are sold. But try to ensure that your client gets the assets with the highest cost basis. Low basis assets will trigger a much bigger capital gains tax bill at the time of sale.

If, on the other hand, your client makes substantially more money than his spouse and has the cash available, he may opt to pay his spouse's fair share of their estate rather than splitting and selling all his assets.

Is it Alimony or Child Support?

Alimony must be required by a divorce or separation instrument and be in cash. The alimony payments are tax deductible to the payer. Therefore, the receiver of alimony must include that money in income and pay tax on the money.

But child-support payments are not deductible to the payer. So many people try to camouflage child support as alimony to qualify for the deduction. But the Internal Revenue Service is aware of this tactic. If the so-called “alimony” ends on a child's milestone, say, his 18th birthday or the day he goes off to college, the IRS will know those payments were masked child support. Back taxes may then be owed on that previously deductible money.

In addition, be careful of “front loading” the alimony payments. If, for instance, instead of cashing out $50,000 in stock at the time of the divorce as a property settlement, one spouse may opt to pay, say, $20,000 over the next three years to the other spouse as alimony. Now the payer gets a $20,000 alimony deduction, while the receiving spouse will owe tax on it.

But there is an IRS rule to prevent this “front loading” of alimony. The alimony recapture rules prevent the payer from handing over large sums in the first three years and then decreasing or terminating payments after that. To avoid confusion, be sure to call such payments, “a property settlement” in the divorce documents, says Carol Ann Wilson, president of the College for Divorce Specialists in Boulder, CO.

For more advanced planning, consider a divorce settlement trust, known as an alimony trust. Put your client's income-producing property (stocks, real estate, cash) in a trust and use that income to make the alimony payments. There is no tax on the funding of the trust, thanks to a section of the tax code that gives divorced people a break, notes McCaffrey. And because it's his trust, he can decide when the payments will end.

Let's say he put $1 million in a trust. He decides with his ex that the trust will pay her $50,000 in annually until their child hits 18. While there is no alimony deduction for the money paid out to the ex-spouse from the trust, the money is out of the estate. And the appreciation will be tax-free as well, unless it is higher than the spousal payments. So if the ex-spouse is paid $50,000 a year and the trust earns $60,000, the ex-spouse will owe tax on $50,000 and your client will owe tax on the $10,000 difference.

The tax burden is shifted to the ex with this trust, because she will be taxed on the payment. Remember, child support payments typically are tax-free. In this case, they're not. But the upside for the ex is that the trust offers payment security. The money is going to keep coming for the allotted time because the trustee will control it.

Who Gets the House?

What happens with the house? It is generally understood that the ex-spouse needs to live there while the kids are still at home. But your client doesn't want to turn over the title, especially because her new husband is now living there.

Consider recommending that they keep joint ownership of the home until it is sold. Typically, if a home is sold for a gain, a couple will not owe tax on the first $500,000 as long as the home was their primary residence for two of the last five years. So if your client moves out and turns over title, he will lose out on any gain when the house is sold.

But there's a perk in the tax code for divorced people that will let them both share in the gain. As long as the home's title is still in both of their names, they'll each get a $250,000 capital gain exclusion at the time of sale, even if he's been out of the house for more than five years, says Wilson. Be aware though: He would not qualify for that exclusion if he sold another home for a gain within the two years prior to the sale of the jointly owned home. The IRS only allows this exclusion once every two years.

If your client wants to ensure that the kids get the house, consider a Qualified Personal Residence Trust, a QPRT. (See page 50 for more details.) But the trust will get the house out of your client's estate and be left for the kids. This way, any appreciation on the house is passed on, estate-tax-free.

Does the New Spouse Come with a New Trust?

Trust planning is imperative when clients remarry. Regardless of how great your client believes his new spouse is, insist he implement controls that will allow him to manage all aspects of his estate after his death.

“The Qualified Terminable Interest Property Trust, a QTIP trust, was created just for these nontraditional family situations,” says Betsy McKenna, estate planning specialist, at RIA, a New York-based provider of tax information and software to professionals.

This trust will give your client the ability to support his new surviving spouse financially without having to fret about her properly allocating enough for his kids after his death. So he can ensure that his kids (or someone else) will get the remainder of the account after his surviving spouse is gone.

With the QTIP, the surviving spouse will qualify for the marital deduction. That means there's no estate tax on what goes into the QTIP. In addition, the QTIP has a few rules that must be followed. The surviving spouse can be the only beneficiary of the trust during her lifetime. The surviving spouse cannot touch the principal and any income generated must be distributed to the surviving spouse.

There's more to divorce and remarriage then who gets the kids for the holidays. Everything is touchy, and most people are on edge when discussing this stuff. So do your clients a favor — remain upbeat and sincere but insist then do sufficient planning for their heirs. Then it's your job to revisit that plan and make sure it still makes sense. While you can't ensure that marriage number two (or three) will work out, you can make certain that your client's money ends up in the right hands after his death.

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