Unlikely as it may seem, there are some beneficiaries who prefer not to receive inherited assets. The reasons vary: Often the beneficiary would like the assets, such as a traditional or Roth IRA or other inherited retirement plan, to be given to someone else. Other times the original beneficiary does not want to be taxed on the assets.
A common estate-planning strategy for married couples is for each spouse to leave the other all of their assets 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 means that the decedent misses out on using their exemption equivalent.
Furthermore, the surviving spouse might not even need the inherited money to support their lifestyle, yet the decedent's assets will be included in the survivor's estate at the time of the survivor's death.
If you are considering disclaiming an inheritance, you need to understand the effect of your disclaimer and the procedure you must follow to ensure that your disclaimer is considered qualified under federal and state law. Here's how a qualified disclaimer works and what you need to consider.
- Common reasons for disclaiming an inheritance include not wishing to pay taxes on the assets or ensuring that the inheritance goes to another beneficiary—for example, a grandchild.
- Specific IRS requirements must be followed in order for a disclaimer to be qualified under federal law. It's important to find out what your state's requirements are as well.
- There are ways to disclaim an IRA that might allow a child or grandchild to benefit from greater growth of the funds, provided primary and contingent beneficiary forms have been properly filled out.
- When executed correctly, a qualified disclaimer could save a family hundreds of thousands of dollars in federal taxes.
The Right Way to Use 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 to 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. However, it's also possible to disclaim only a percentage of the inherited assets. For these reasons, 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:
- Provide an irrevocable and unqualified refusal to accept the assets
- Make the disclaimer in writing
- Disclaim the asset within nine months of the death of the assets' original owner (one exception: if a minor beneficiary wishes 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
Some states require the disclaimer to include a statement that says the person disclaiming the assets is not subject to any bankruptcy proceedings. Anyone disclaiming assets should seek legal advice on the laws of their state of residence.
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.
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' beneficiary life expectancy table listed in Publication 590-B Appendix B, Table 1. Income taxes on assets received from an inherited IRA are due on each distribution.
Before a beneficiary removes assets from an IRA, they 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. A 60-year-old beneficiary, for example, 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 they inherit the IRA, you need to plan ahead. You should ask yourself these two questions:
- Do you have a current will?
- 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).
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.
Leaving an Income
Another estate-planning tool that uses disclaimers is a disclaimer trust. You can use this type of 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, but the surviving spouse has nine months to decide how much to put in the trust, depending on their situation and the inheritance-tax laws at that time.
Typically, your surviving spouse will be the income beneficiary of the trust, but they cannot withdraw principal. Following their death, the trust assets usually pass to the next beneficiary in line, thereby avoiding federal estate taxes along the way.
A disclaimer trust 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 trust could save a family hundreds of thousands of dollars in federal taxes.
Other Reasons to Disclaim Inherited Assets
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
John designates his son, Tim, as the sole beneficiary of the assets in his retirement plan. When John dies a few years later, Tim stands to inherit the money, but if he does, he will no longer be eligible for student aid at college. Tim decides to disclaim the assets. He therefore properly disclaims the assets and is now treated as if he never was the designated beneficiary.
Note, as explained above, that if John designated a contingent beneficiary, that person (or entity), would become the successor beneficiary.
The Bottom Line
Trusts can be used in estate planning to give individuals and couples greater control over how assets are transferred to heirs with the fewest tax consequences. Sometimes, however, disclaiming assets makes the most sense.
No special form or document must be completed to disclaim inherited assets. A letter usually suffices, providing it meets the above requirements. To ensure that any special requests are honored by the custodian/trustee of a retirement account if you are disclaiming those assets, check first with the custodian/trustee regarding the manner in which these requests should be handled.
Talk to your tax professional to find out under which circumstances tax consequences could arise when disclaiming inherited assets. These may not apply to you, but they may apply to the successor beneficiary. Some disclaimers may require court approval if, for instance, the individual disclaiming the assets is mentally incapacitated or a minor.
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. Use the information here as a guide to issues you should discuss and options to consider; it should not be used as legal advice.