A Unified Credit Shelter Trust (UCST) will typically provide a surviving spouse with trust income and the right to invade trust principal for health, maintenance and support. After the surviving spouse’s death, the amount in the trust passes to named beneficiaries (usually, the couple’s children). The purpose of a UCST is not only to provide the surviving spouse with income, but also to protect trust principal from estate taxes. If properly drafted and executed, the balance of a UCST at the second death will not be subject to estate taxes because the first decedent used, instead of wasted, his unified credit (the "exemption equivalent" amount). It is preferable to create a UCST with discretionary, not mandatory, income distributions to the surviving spouse; because UCSTs do not have to qualify for the marital deduction, income distributions are not required. The purpose of making income distributions discretionary is to create a post-mortem option of allowing the trust to grow. After the surviving spouse’s death, the trust (with additional accumulations) would pass to heirs (usually children) free of estate taxes.

Traditionally, tax advisers have preferred to fund their clients’ UCSTs with after-tax dollars and/or life insurance proceeds. Some tax and estate planning attorneys, however, customarily draft intricate IRA and retirement plan beneficiary designations that have the effect of funding UCSTs with IRA or other retirement accounts if they are needed to fund the trust fully. The strategy of using IRAs and retirement plans to fund a UCST will become more popular as the post-TRA ’97 Sec. 2010(c) exemption equivalent increases from $600,000 in 1997 to $1 million by 2006³, and the contributions and growth in IRAs and retirement plans continue.

Use of disclaimers: IRA owners should consider disclaimer provisions for their IRA beneficiary designation. These sophisticated IRA and retirement plan beneficiary designations should consider the use of disclaimer provisions. The disclaimer strategy will typically name the surviving spouse as the primary beneficiary and the UCST as the secondary beneficiary of the retirement plan or IRA. The disclaimer strategy allows a "free second look" for a surviving spouse to decide whether to retain all of the IRA proceeds outright (using the marital deduction) or to disclaim all or a portion of the IRA proceeds into the UCST. The surviving spouse makes this decision after the first death, when the financial picture of the survivor and the family is known.

If the disclaimer strategy is used in both the will (or revocable trust) and the IRA with integrated language between the will and IRA beneficiary designation, the surviving spouse would be able to choose which assets (if any) would be used to fund the trust. Having disclaimers in both the will and the IRA is referred to as a "double disclaimer" strategy. In many cases, this strategy will yield a better result than drafting wills and IRA beneficiary designations based on projections about who will die first, when they will die, the family’s needs, and the amount of after-tax and IRA funds available to fund the UCST.

Advisers usually prefer funding a UCST with after-tax funds, if available, instead of pre-tax funds, because an after-tax dollar is worth more to an heir than a pre-tax dollar. The income in respect of a decedent associated with pre-tax funds diminishes the value of the UCST to the heir; however, Sec. 691 does not apply to a Roth IRA. Thus, advisers should at least consider whether funding the UCST with Roth IRAs is preferable to using after-tax accumulations. If the marital bequest or the surviving spouse’s independent assets suffice to make the surviving spouse financially secure, children or grandchildren should be named as the beneficiaries of Roth IRAs to the extent of the exemption equivalent. The long life expectancy of a young beneficiary would require smaller minimum distributions in early years, thereby resulting in significant tax-free growth of the Roth IRA. Although this strategy is good for regular IRAs, it provides an estate planning bonus with Roth IRAs.

Naming children instead of the surviving spouse as the primary beneficiaries will be advisable only in larger estates. When the security of having the principal and income of the exemption equivalent amount available to the surviving spouse is desired, the adviser should consider recommending a double-disclaimer strategy. The client could take a "wait and see" approach and allow the surviving spouse to determine the optimal strategy after the first death, when more information is available.

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The Roth IRA provides significant opportunities for tax-free growth. In most cases, annual contributions should be made to Roth IRAs instead of regular IRAs. Further, the benefits of the Roth IRA are so substantial that practically all clients who qualify should consider whether it would be beneficial to convert at least a portion of their existing IRAs to a Roth IRA. Because the analysis of whether to make this conversion is so important and complex, there is an opportunity for tax advisers to provide substantial assistance to their clients.

Author’s Note: The author specially thanks Steven T. Kohman, CPA, for his quantitative analysis and Scott L. Olson for his research and editorial assistance with this article.