A common estate planning strategy for married couples is for each spouse to leave the other all of his or her assets in order to take advantage of the unlimited marital deduction. Doing this will reduce the size of the deceased's estate and eliminate the immediate estate tax. However, this could mean that the decedent misses out on using his or her exemption equivalent. Furthermore, the surviving spouse might not even need the inherited money to support his or her lifestyle, yet the decedent's assets will be included in the survivor's estate at the time of the survivor's death. Here we look at how a qualified disclaimer works and what you need to consider when disclaiming an inheritance.

Qualified Disclaimers

If a person has not set up an exemption trust prior to his or her death, a qualified disclaimer can be useful. It enables the beneficiary to refuse to accept part or all of the assets, rather than receive them. The assets would then pass to the contingent beneficiary, bypass the estate of the first beneficiary (the surviving spouse), and use the first decedent's exemption equivalent.

For tax purposes, disclaiming assets is the same as never having owned them. That's why it's important to follow the precise requirements of a qualified disclaimer. If the primary beneficiary does not follow these requirements, the property in question will be considered a personal asset that he or she has given as a taxable gift to the next beneficiary in line.

According to the IRS, the person disclaiming the asset must meet the following requirements to use a disclaimer:

  • Make the disclaimer in writing
  • Disclaim the asset within nine months of the death of the assets' original owner (in the case of a minor beneficiary wishing to disclaim, the disclaimer cannot take place until after the minor reaches the age of majority)
  • The person disclaiming cannot have benefited from the proceeds of the disclaimed property
  • The person disclaiming cannot have the assets indirectly pass to him or her

Keep in mind that the disclaimer is irrevocable; the person who disclaims the property can't come back later, after a failed business or stock market slump, for example, and reclaim those assets.

What Becomes of the Assets?
The person disclaiming the assets does not get to choose who is next in line to receive the disclaimed property. Instead, the assets will pass to the contingent beneficiary as if the first beneficiary had died. In the case of an intestate death, state law will determine the next beneficiary. (For further reading, see Getting Started On Your Estate Plan and Skipping Out On Probate Costs.)

Extra Benefits for IRA Heirs
Whoever eventually inherits an IRA must remove the funds contained in the IRA no later than the time allowed per the IRS's beneficiary life expectancy table listed in Publication 590, Appendix C, Table 1. Income taxes on assets received from an inherited IRA are due on each distribution.

Before a beneficiary removes assets from an IRA, he or she should consider how the IRA's contents might grow if a younger person - for example, a child or a grandchild - were to receive the account. For example, a 60-year-old beneficiary would have to liquidate the IRA within 25.2 years. But if that beneficiary disclaimed the account and a 20-year-old grandchild were the contingent beneficiary, the money could remain in the IRA for 63 years. That's almost four decades of additional tax-deferred growth. Plus, the grandchild might be in a lower income tax bracket than the original beneficiary.

However, if you have an IRA and you wish to give your primary beneficiary this added flexibility when he or she inherits the IRA, you need to plan ahead. You should ask yourself these two questions:

  1. Do you have a current will?
  2. Did you or your lawyer include a contingent beneficiary in your will?

To answer these questions, you'll have to find your will and double check its contents. Also, don't forget the IRA beneficiary form you filled out when you opened your IRA. The form has spaces for you to name primary and contingent IRA beneficiaries. Check with your IRA custodian to confirm they have the correct information, or have your lawyer check on your behalf. It is important to update your IRA beneficiary form as changes occur in your family or your personal situation (e.g. the death of a beneficiary). (To learn more, see Who Is The Beneficiary Of Your Account?)

Leaving an Income
You can use a disclaiming trust
to make sure that your beneficiary will have an income from the disclaimed property. However, the trust must be established while you are alive. Assets up to the amount of your available exemption equivalent can transfer to the trust after your death. Typically, your surviving spouse will be the income beneficiary of the trust, but he or she cannot withdraw principal. Following his or her death, the trust assets usually pass to the next beneficiary in line, thereby avoiding federal estate taxes along the way.

Other Reasons to Disclaim
In addition to reducing federal estate and income taxes, there are a few more reasons why a beneficiary may want to disclaim inherited assets:

  • To avoid receiving undesirable real property, such as an eroding beachfront property or property with high real estate taxes that may take a long time to sell
  • To avoid subjecting the assets to creditors in case the primary beneficiary is involved in a lawsuit or bankruptcy proceeding
  • To benefit another family member - for example, a college-age grandchild who could use an inherited car
  • To take advantage of another beneficiary's lower income tax bracket

A disclaimer can give your survivors the flexibility they need to deal with shifting exemption equivalent amounts, tax laws, family needs and net worth. Plus, it is a method of post-mortem estate planning that gives you some control over who eventually ends up with your assets. When executed correctly, a qualified disclaimer could save a family hundreds of thousands of dollars in federal taxes. As with any financial planning decision, it is best to seek the advice of a professional who specializes in this area to avoid making errors that can complicate estate executions.

For further reading, check out Get Ready For The Estate Tax Phase-Out and Disclaiming Inherited Plan Assets.

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