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Disclaiming an IRA Inheritance

By: Investor Solutions

By: Investor Solutions, Inc.

Saying “no thanks” or refusing an inheritance, now who in the heck would want to do something as stupid as that? Well, if it’s debt you stand to inherit, we would both make a run for the hills. But wait, what if you’re in line to inherit a million dollar IRA and you just don’t want or need the money? For most people, this scenario may not sound too familiar, but believe it or not- disclaiming an IRA inheritance can work quite nicely in your estate plan.

IRA’s are a great savings tool, for one because they allow your money to grow tax-deferred over your lifetime. When you couple that with some of the changes in the tax law, you’ll realize that you can extend the same tax-deferral of your IRA to your family as well. When designing your estate plan, it may appear simple to make a trust the beneficiary of all of your assets to allow a trustee to distribute the assets according to your wishes. However, IRAs and other retirement assets should generally be left outright to the intended beneficiaries, unless there is a convincing reason that leaving them to the trust would be better (for example, minors as beneficiaries).

What is a Disclaimer? A disclaimer is a refusal by a potential beneficiary to accept benefits given through a transfer of property. In most cases, a primary beneficiary will “disclaim” or refuse to accept the property, the property will then pass gift tax-free to the contingent beneficiary. If the rules are followed, the IRS does not interpret the disclaimant as ever receiving the property. Therefore, no transfer is considered to have been made by the disclaimant for federal gift, estate, or generation-skipping transfer tax purposes. The following rules must be followed in order to meet the requirements of a “Qualified Disclaimer”:

Requirements for a Qualified Disclaimer under IRS Section 2518:

  • The Disclaimer must be irrevocable, unconditional, and in writing.
  • The written disclaimer must be delivered to the current holder of legal title.
  • The disclaimer must be made within nine (9) months of the date of death. If the person disclaiming has not yet reached age 21, the deadline is extended to nine months after obtaining age 21, whichever is later.
  • The disclaimant must not have accepted any interest in the benefits.
  • As a result of the disclaimer, the property must pass to someone other than the disclaimant. (exception for spouses)
  • The property must pass, as a result of the disclaimer, to whoever it passes without any direction on the part of the disclaimant.[1]

The first four qualifications above are self explanatory, however; the last two may need some clarification. When stating that the property must pass to someone other than the disclaimant, this means that once the property is disclaimed to the contingent beneficiary, it cannot pass to a trust where the disclaimant is named as the beneficiary. The spouse is the only exception to this rule. Under the last rule “no direction on the part of the disclaimant”, if the contingent beneficiary is a trust, the disclaimant is not permitted to serve as the trustee of the trust since the disclaimant would now be given the powers to distribute principal under the trust agreement.

Listed below are three scenarios where disclaimers might be used as a practical estate planning tool:

a) Property is left to a spouse who does not need it. The spouse can then disclaim the property and let it pass to the contingent beneficiary. In some estate planning cases, a credit shelter trust is named as the contingent beneficiary of the IRA. When the IRA owner dies, the spouse then has the flexibility to disclaim the IRA and let it pass directly into the credit shelter trust. This allows you to fully utilize the available unified credit. If the spouse has general powers over the marital trust they must be disclaimed as well, this still enables the surviving spouse to take advantage of lifetime income from the trust.

b) The primary beneficiary wants to make a tax-free gift to the contingent beneficiary.

c) A parent receives a large bequest from a relative and would like the assets to pass to the next beneficiary in line.

Example:

Tim dies, leaving his entire IRA ($1 million) to his primary beneficiary (his wife Tammy). If Tammy does not need the IRA assets, she can disclaim the property and let it pass directly to the contingent beneficiary (the children directly, credit shelter trust, or whomever is specified on the IRA). By disclaiming the property within 9 months of Tim’s date of death, Tammy has not made a gift to the children/contingent beneficiary.

A disclaimer generally gives the spouse more flexibility to decide if he/she needs the IRA funds. If the inheriting spouse is over 70 ½ years of age, accepting the inheritance may trigger an RMD (required minimum distribution) which means more taxable income to the spouse. If a surviving spouse disclaims to the children (the contingent beneficiary), they will only be required to take required minimum distributions at the rates under their life expectancy table. That means the child would likely have a much lower RMD than the surviving spouse. The disclaimer allows the surviving spouse the freedom to determine if there’s a need for him/her to accept the inheritance of the additional assets. If estate planning is a concern to the surviving spouse, this gives him/her the opportunity to do some estate planning on their life within the next 9 months to determine the effect of accepting the IRA assets.

If you’re fascinated by the idea of an extended tax-deferral period for the children based on their longer life expectancies, think about the incredible benefits of disclaiming. Suppose your children are highly successful and they disclaim the IRA (as the contingent beneficiary), then the IRA could pass to your grandchildren (assuming that you named them as a third tier beneficiary). Then the third generation children could take the RMD over their quite long life expectancy. You can’t beat that deal. It’s critical that you annually verify and update the beneficiaries that are designated to your IRA. The IRA beneficiaries listed there will take precedence over any will or living trust that dictates the disposition of your retirement assets at death.

[1] Life and Death Planning for Retirement Benefits, Natalie Choate, 4th Edition, 2001