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Passing the Bucks

Want to share your nest egg across the generations? A disclaimer gives a surviving spouse the right to play dead so that IRA assets can be transferred to others.
Marie Leone, CFO Magazine
November 1, 2006

Walter Dollard was never one to procrastinate — until he retired.

During a 37-year career at Westinghouse Electric, the mechanical and nuclear-power engineer was able to accumulate a sizable nest egg. After retiring at age 62, he consolidated it by taking his pension in a lump sum and transferring that money and proceeds from his 401(k) into an individual retirement account (IRA).

Thus began his procrastination — in paying taxes. Because he and his wife were able to live on other funds, Dollard, now 74, was able to leave the IRA untouched, and it grew substantially with no tax hit.

Until, that is, he reached age 70 1/2, at which time he was obligated to begin taking a minimum required distribution (MRD) from the account — and pay taxes. And because the guidelines governing MRDs tend to increase the amount an IRA owner must withdraw each year, Dollard was faced with an ever-increasing tax liability, and the possibility that he would not be able to pass along as much of his estate as he hoped to his wife and children.

Fortunately, because he had moved much of his retirement fund into an IRA, he was able to attach a "disclaimer" to his IRA beneficiary designation form. Disclaimers do two things: they establish a sort of "hierarchy of heirs," or what estate-planning attorney James Lange, author of Retire Secure: Pay Taxes Later, calls a "cascading beneficiary plan," and they give a surviving spouse more options regarding how to handle inherited IRAs.

A disclaimer gives the primary beneficiary of the IRA, in this case Dollard's wife, the right to "disclaim," or refuse, all or part of the IRA. Once the primary beneficiary disclaims the IRA, the account passes to the contingent beneficiary named on the designation form or in the will. The contingent beneficiary has the choice of keeping or disclaiming all or part of the IRA, and the cascade continues until the IRA runs out.

That gives a family flexibility, explains Lange. For one thing, since estate-tax laws are constantly changing, each primary beneficiary can make choices about whether to accept, pass along, or divide the account based on the law as written at the time that decisions must be made. In a case where one or more children or grandchildren may need more resources than others, it provides an avenue for addressing individual needs by allowing, for example, one child to disclaim his or her share, so that it passes intact to others (see "Heir Tactics" at the end of this article).

Tax Fictions and Black Holes
A disclaimer works with the tax law because it creates a fiction, says Jere Doyle, senior vice president of Mellon Financial's Private Wealth Group. In the eyes of the IRS, the person disclaiming is considered dead. The concept is not as morbid as it sounds. "For tax purposes, the person disclaiming is deemed to have predeceased the IRA owner, which allows all or part of the account to pass to the contingent beneficiary," Doyle explains.

The strategy addresses the often ignored distribution side of the inheritance equation. "Distribution planning is the black hole of estate planning," contends Ed Slott, an IRA expert and author of Parlay Your IRA into a Family Fortune. He says that too often investment advisers focus on wealth accumulation, while accountants come in after the estate-planning sessions to tally the tax damage. But distribution planning has begun to receive attention in the past few years, particularly among those who are not worried about outliving their retirement assets, but who want to ensure that such assets pass to others with as small a tax bite as possible.

Although disclaimers were written into the U.S. Tax Code in 1976, they did not become popular components of retirement strategies until retirement account balances began to swell in the late 1990s. That was also about the time Congress raised the estate-tax lifetime exemption, which coaxed more retirees to take advantage of the tax break. In aggregate, IRA assets hit a record $3.7 trillion in 2005, up from $3.3 trillion in 2004 and $2.7 trillion in 1999, according to the Investment Company Institute, a trade organization.

With that much family wealth tied up in IRAs, the use of disclaimers is likely to rise. But disclaimers are complicated to construct, and you will have to hire a lawyer to assemble one, says Mellon Financial's Doyle. Disclaimers require a significant amount of discussion about estate planning and strict attention to detail in order to create an effective plan.

In fact, while most retirement plans accept disclaimers, some don't allow them, because they are deemed too cumbersome to process, notes Doyle. Primary beneficiaries must notify the IRA custodian and complete their disclaimers within nine months of the account owner's death. In addition, the beneficiaries cannot have accepted any (prior) interest in the IRA, and the person disclaiming the inheritance cannot direct the funds. The money must flow in accordance with the owner's will or beneficiary- designation form. And while most state laws follow federal law, some don't: in Massachusetts, for example, disclaimers used on probate property have to be approved by a probate court.


Surprisingly, Slott says, one of the most common mistakes IRA owners make regarding disclaimers is that they don't name contingent beneficiaries, or don't update the list to reflect changing circumstances such as births, deaths, marriages, and divorces. The documents also don't work well for nontraditional families, especially when the surviving spouse is a stepparent who has less-than-ideal relationships with the children of the original IRA owner. Because each primary beneficiary has discretion over how or whether to take all or part of the IRA and pass any remainder along, even the most carefully constructed disclaimer becomes a matter of trust.

Marie Leone is senior editor of CFO.com.


Heir Tactics

As an example of how an IRA disclaimer might work, consider a scenario in which a husband dies and his wife inherits $1 million in aftertax money and an IRA worth $3 million. The IRS's unlimited marital deduction allows the wife to inherit everything without paying estate taxes. But if the wife accepts the full IRA, two things will happen: she will be forced to take an annual minimum required distribution (MRD), which will deplete the IRA principal and entail a tax hit, and by accepting the full $3 million she may overfund her estate and force her heirs to cope with estate- and income-tax payments they might have avoided.

The wife talks to her two adult children and finds that her daughter is doing well financially but her son could use some help. The wife therefore accepts only $2 million of the IRA and disclaims the remaining $1 million, which passes to her two children. The daughter disclaims all of her share, which passes to the next beneficiary named by the disclaimer, a trust set up for her 14-year-old daughter. (The granddaughter's trust must begin accepting the annual MRD immediately, but the withdrawal is small because it is based on the granddaughter's life expectancy, so the IRA principal is stretched further.)

Meanwhile, the son, who has twin boys, accepts half of his share and disclaims the rest, which passes to a trust for his twins. The son begins withdrawing and paying taxes on the MRDs, getting a useful cash infusion.

By making an IRA disclaimer part of his estate planning, the original IRA owner was able to stretch that account so that it reached his grandchildren, while providing financial support to his wife and son along the way. Not a bad way to feed a family on one nest egg. — M.L.




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