Disclaiming Inherited Plan Assets

Unlikely as it may seem, some beneficiaries prefer not to receive inherited assets, and the reasons can vary. Often the beneficiary would prefer the assets be given to someone else. Other times the original beneficiary doesn't want to be taxed on the assets. If done correctly and permitted by state law, the reason may be to shield the disclaimed assets from seizure during bankruptcy proceedings.

If you are considering disclaiming an individual retirement account (IRA) or other inherited retirement plan, you need to understand the effect of your disclaimer and the procedure you must follow to ensure that your disclaimer is qualified under federal and state law.

Reasons for Disclaiming Inherited Assets

If a beneficiary properly disclaims inherited retirement assets, their status as a beneficiary is fully annulled—it's as if they never were the designated beneficiary. This individual, therefore, will not owe federal or estate taxes on the assets. Instead, the successor beneficiary will be responsible for paying any taxes due on the amount. A beneficiary without a need for the inherited funds may prefer to pass the inheritance to another family member in a lower tax bracket.

Disclaiming inherited assets is not only for avoiding taxes. In some instances, beneficiaries disclaim assets so that other certain individuals receive the assets. The beneficiary disclaiming the assets; however, must be aware of the effect of the disclaimer, especially if the intention is to have a specific person become the successor beneficiary. The beneficiary disclaiming the asset is not allowed to designate who is next in line to receive the asset. It would then pass to the contingent beneficiary designated in the plan documents by the original owner.

For example, assume John designates his son, Tim, as the sole beneficiary of the assets in his retirement plan. 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. Tim properly disclaims the assets and is now treated as if he never was the designated beneficiary.

It is important to note that if John designated a contingent beneficiary, that individual (or entity), would become the successor beneficiary.

SECURE Act: Impact on Inherited Retirement Assets

2019 and Prior

Before the SECURE Act, passed in December 2019, beneficiaries of IRAs had the ability to "stretch" IRA distributions over multiple generations. It was an effective wealth transfer method that minimized taxes. Inherited IRAs had required minimum distributions (RMDs) that had to be taken every year, based on the life expectancy of the person who inherited the IRA.

This method was especially beneficial for younger beneficiaries who had a long remaining life expectancy, as they could "stretch" the length of time they had to take IRA distributions while allowing the remainder to grow tax-free. This could have been a reason to pass an inheritance to a younger beneficiary in the past.

2020 and Later

The SECURE Act has modified the rules around inherited retirement plans considerably, for any plan owner who dies Dec. 31, 2019, or later. Under the new legislation, beneficiaries are classified as one of three different categories: eligible designated beneficiaries (EDBs), designated beneficiaries (DBs), and those not considered designated beneficiaries.

Eligible designated beneficiaries (EDBs) are anyone designated by the IRA owner who is:

1. A spouse
2. Minor child(ren)
3. A chronically ill individual
4. A disabled individual
5. Someone not more than 10 years younger than the IRA owner

Non-person entities such as trusts, charities, and estates are in the third category, not classified as designated beneficiaries. Most non-spouse beneficiaries will, therefore, fall into the second category of designated beneficiaries, which includes most adult children.

10-Year Rule

Individuals in the DB category must withdraw all inherited IRA funds within 10 years of the death of the original account holder. Additionally, second-generation beneficiaries who inherit in 2020 or later are no longer able to "stretch" their distributions, even if the original IRA owner passed away before 2020. They will instead be subject to the ten-year payout rules. Therefore, if a beneficiary in the second or third classifications described above is due to receive an inheritance, it may make better financial sense to disclaim the asset if the contingent beneficiary is in the EDB category.

For example, assume again that John designated his adult son, Tim, as his retirement beneficiary. John passes away in February 2020. John’s wife (and Tim’s mother) Sarah is still alive, and she is the contingent beneficiary listed in John’s plan documents. Although Tim is due to receive the inheritance, he would have to withdraw the funds over the following 10-year period.

After speaking to an attorney, he decides to disclaim the inheritance so the funds can go to his mother. Sarah is then able to take the funds out of the account over a longer period of time using the life expectancy method. This would also be beneficial if she were in a lower tax bracket than Tim. For example, if Tim were in his prime earning years, while Sarah had already retired.

Qualified Disclaimers

A beneficiary may also choose to disclaim only a percentage of the inherited assets. This is acceptable if the disclaimer meets certain requirements, in which case the asset will be treated as though it never were the property of the original beneficiary.

A disclaimer that does not meet basic requirements under federal and state law could cause adverse consequences for the person disclaiming the assets and any individuals who are beneficiaries resulting from the disclaimer. If done improperly, the asset may be considered a “gift” under tax law from the original beneficiary to the successor beneficiary.

The following are the requirements that must be met for a disclaimer to be qualified:

• The beneficiary must not have accepted any of the inherited assets prior to the disclaimer.
• The beneficiary must provide an irrevocable and unqualified (unconditional) refusal to accept the assets.
  The refusal must be in writing.
  The assets must pass to the successor beneficiary without any direction on the part of the person making the disclaimer.
  The document must be submitted to the retirement account custodian at the later of the following times:
  Nine months after the retirement account owner dies.
• Nine months after the beneficiary attains age 21 if they are under the age of majority when the retirement account owner dies.

A disclaimer may be legal under federal law, but not valid under state law. Anyone disclaiming assets should seek both tax and legal advice on the laws of their state of residence.

The Bottom Line: Documentation

There is no special form or document that an individual must complete 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 or trustee of the retirement account, an individual disclaiming inherited assets should check with the custodian or trustee regarding how 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 apply to you, or 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.

Beneficiaries who are considering disclaiming assets must seek legal advice to ensure their disclaimers meet both federal and state requirements.