Main Topics
KEY IDEA
An individual who disclaims an inheritance simply steps aside and the next person in line (the contingent beneficiary or beneficiaries) inherits. Planning with this option in mind allows a family to assess and respond to the actual financial needs of the family after the death of the first spouse.
How Disclaimers Work
In traditional families, the standard procedure is for the IRA owner to name his or her spouse as the primary beneficiary and their children equally as contingent beneficiaries (the same ingredients of the I Love You will). But here is the key point: the surviving spouse always has the option to accept or refuse the inherited IRA. He or she can disclaim the entire IRA or a portion of the inherited IRA. But why on earth would someone not want to accept an inheritance? Because refusing (disclaiming) an inheritance can provide significant tax benefits to the family.
The surviving spouse always
has the option to accept
or refuse the inherited IRA.
He or she can disclaim the
entire inherited IRA or a
portion of the inherited IRA.
Let ’s assume that your spouse names you as the beneficiary of his/her $3 million IRA, and your three children as secondary beneficiaries. If, after running the numbers, you conclude you will be completely comfortable financially with your current income plus $2 million of your spouse’s IRA, consider disclaiming $1 million to be split among your children. Assuming that your disclaimer meets the federal requirements for a qualified disclaimer and the applicable state law requirements for a valid disclaimer (as described later in this chapter), you can do just that. The IRA can then be divided into as many Inherited IRAs as there are secondary beneficiaries – in this case, three, for your children. No matter how large the IRA, the surviving spouse will not be deemed as having made a gift for gift or estate tax purposes. It is as if the deceased IRA owner left $2 million to their spouse and the remaining $1 million to their children. Then, each child will be required to take minimum distributions from his or her Inherited IRA based on his or her individual life expectancy.
You cannot change
beneficiaries after the IRA
owner dies. Disclaiming
simply means that one
beneficiary steps aside in
favor of the next beneficiary
or beneficiaries.
Please do not misunderstand this concept. You cannot change the beneficiaries on the account after the original IRA owner dies. If the three children were named equally as the contingent beneficiaries, the surviving spouse cannot pick and choose among the children, nor alter the amounts or percentages they receive. The surviving spouse can only disclaim to all three children in equal shares, if that was what the original owner had specified when he filled out his beneficiary form.
Disclaiming simply means that one beneficiary steps aside in favor of the next beneficiary or beneficiaries. Should the first beneficiary disclaim, under current law the contingent beneficiary is able to use his or her life expectancy to determine the Required Minimum Distribution (RMD) of the inherited IRA, allowing the IRA to be stretched. Even if the law does change and non-spousal beneficiaries are required to withdraw all of the money from the IRA in five years, it still can make sense in many cases for the primary beneficiary to step aside and disclaim an inheritance, though the extended or “stretch” income tax savings of disclaiming under current law would be gone.
Under most state disclaimer laws, the surviving spouse has nine months to decide whether or not to accept, disclaim, or partially accept and partially disclaim his or her interest in the estate. That time lag can help prevent hasty decisions. You can take the time to evaluate your financial position and the consequences of the disclaimer, before you make a decision. In our practice, I never hurry the surviving spouse to make that critical decision. If anything, I want to make sure that whatever decision is made, it is well thought out and preferably made after “running the numbers” to compare various disclaimer amounts. We have saved many families millions of dollars of income taxes through the proactive use of disclaimers. Of course the primary goal is to protect or over-protect the surviving spouse. That said, disclaimers can offer enormous tax advantages, especially for surviving spouses who are wealthy but not spenders.
The other advantage of disclaimers, which is harder to quantify, is that the children will get access to a portion of the family estate while they are still young enough to enjoy it. I sometimes ask my clients if they would change their lifestyle if they were to inherit $1 million dollars tomorrow. Most of them say no. Most of them say they would not even go out to dinner more frequently! But, if I ask them if they had inherited even $100,000 thirty years ago, they all say it would have been a life-changing event.
Many of my clients are financially comfortable and relatively set in their ways. They aren’t going to radically change their spending patterns, even after a death of one spouse. Their children, on the other hand, are usually struggling, even if they have good incomes. When young adults are starting their own families, they frequently face challenging financial pressures. Raising children is more expensive than ever, especially in terms of education (and not just college). Perhaps there are excellent private secondary schools that your grandchildren would benefit from. Does it make sense to sit on millions of dollars that are not about to change your life, but which could have a monumental impact on the lives of your children and grandchildren—and while you are alive to see it?
Even if your children are doing well financially, they have competing pressures on their income including education, housing, their own retirement savings, insurance, lessons, etc. To inherit money earlier in life rather than later could make an enormous difference in the quality of their lives. If you can afford to relieve some of that stress from your children, isn’t that a good thing?
People frequently raise the objection that giving money to a child or children too early will reduce their motivation to work hard. That is actually a very legitimate objection that should be considered on a case by case basis. I would never suggest that you give an irresponsible young adult a free pass to self-indulgence. But, for those who have graduated from college, maybe with an advanced degree, and held down a job for a number of years, or those who are on the road to becoming successful entrepreneurs, a boost in finances at an opportune time could make all the difference in the world.
Please note, these theoretical benefits are in addition to the potentially enormous tax benefits of disclaiming. And, some of the same arguments can be made for gifting!
The requirements for a qualified disclaimer under federal law (which are generally the same requirements as under state law, although you must always review applicable state law to confirm that the proposed disclaimer meets the requirements) include the following:
Avoid This Mistake
After a death, if the named beneficiary is even considering a disclaimer, the most important thing to do is nothing!
The death of a spouse is a very emotional time. If you are the survivor, there is no need to immediately take control of or change the titling of your spouse’s assets. Do not transfer or roll the assets into your name until you have met with your professional advisors and know whether or not you want to disclaim any portion of the inheritance. Although the IRS has permitted disclaimers in certain situations after the spouse has partially accepted the assets (meaning, changed the name on the account, or rolled it or transferred it), it is more prudent and considerably less expensive to not accept any assets until after consulting with a qualified advisor.
It is more prudent
and considerably less
expensive to not accept
any assets until after
consulting with a
qualified advisor.
I recently had a situation where the surviving spouse, in an attempt to save money, tried doing some of the estate administration on her own. She figured she could take care of making the trustee-to-trustee transfer of her husband’s IRA over to her own name before she came in to see us. She filled out paperwork to complete the trustee-to-trustee transfer; later that month, she informed us of her husband’s death and came to see us regarding the rest of the estate administration. I immediately saw the potential for saving hundreds of thousands of dollars for the family by using a disclaimer, something she had forgotten about during this period of stress. Unfortunately, I was too late. Before our office became involved, she took control of the IRA and transferred it into her own name. We could not do a disclaimer on any portion of her husband’s IRA, something that would have provided great benefits to the family.
The death of a spouse is an emotional time. It’s easy to make big mistakes when you’re in an emotional state. Discuss, plan, and prepare ahead of time, and please make sure you have a flexible plan that will survive changes in both the tax code and how your investments do over time. Then your surviving spouse will have all the options at his or her disposal and will have an entire nine months to make decisions on what to do.
Advantages of Disclaimers
A disclaimer offers several potential advantages, but they’re easier to understand by using an example. When reading the following scenarios, please assume that the surviving spouse, Jean, was named as the primary beneficiary of Mike’s IRA and their children were named, equally, as contingent beneficiaries. If Jean disclaims Mike’s IRA or a portion of Mike’s IRA to her children, rather than accepting the inheritance, it accomplishes three objectives.
Many of my clients who have disclaimed to their children have told me later that they were gratified to be able to see their children enjoy their inheritance. If the survivor does not have sufficient income to support their needs, disclaiming is not appropriate and he or she should choose to retain the entire IRA. If the surviving spouse has significantly more money than he or she needs, choosing to disclaim the entire IRA could be a powerful course of action. In some cases, the best solution is for the surviving spouse to keep a portion of the IRA and disclaim the remainder.
In some cases, the
best solution is for the
surviving spouse to keep
a portion of the IRA and
disclaim the remainder.
The beauty of considering a disclaimer as part of your estate plan is that the decision of whether or how much to disclaim can be made after the death of the first spouse, when a much clearer picture of the surviving spouse’s financial situation is available.
In the chapter on Lange’s Cascading Beneficiary plan, we discuss the possibility of using disclaimers over one or even two generations—with our plan, children can disclaim into well-drafted trusts for the benefit of a grand-child. Passing on tax-deferred IRA dollars in this manner could dramatically reduce the RMD of the inherited IRA after the first death.
Please note that using disclaimer strategies is not limited to IRAs and retirement plans. You can incorporate the same flexibility with disclaimers on all the assets in the estate. That will allow the surviving spouse (with help from advisors and family) to determine that best plan after the first death.
For example, in today’s environment and for some readers, the best asset to disclaim to the children might be part of the IRA. On the other hand, in a different environment and in a different situation, the best asset to disclaim might be the Roth IRA, or some after-tax dollars, or even the life insurance. One of the advantages of setting up flexibility ahead of time through the planned use of disclaimers is that you can better assess the proper course of action in the future than you can right now.
Comparing the Disclaimer Approach to a Traditional Approach
If you have an outdated estate plan that includes an A/B trust, the following information is enormously important and similar to the analysis presented in Chapter 11 under the heading “The Cruelest Trap of All.”
The problem with the fixed-in-stone traditional approach used by many attorneys is that no one can predict:
The traditional approach only allows you to guess at what might be an optimal plan for the surviving spouse and family.
The appeal of the traditional approach is that the bequeathing individual exercises control; he or she decides how to leave money at death and sees that the appropriate documents are drafted. This also means that the traditional approach does not allow the surviving spouse to make nearly as many discretionary decisions as the more flexible plan. I cannot emphasize enough the value of structuring your estate planning documents so that they are as flexible as possible.
One problem with a traditional approach is that any plan that is put in place today will likely be far from optimal within one or two years, let alone 10 to 20 years. As the laws change and the balances in the estate and other factors change, the traditional will or beneficiary designation must be redrafted. Then clients, who I am meeting with for the first time, get upset because I have to point out to them why their estate planning documents are not only inefficient, but rather they’re downright dangerous.
The traditional answer to justify the fixed-in-stone approach is that if the situation changes, you can always update your documents. Standard advice recommends people review their will every several years. Good luck with that one. Many if not most of my new clients come in with wills that are ten, sometimes 20 and sometimes 30 years old. Those old wills and documents can never respond adequately to current conditions on either the tax front or, in many cases, the family front. Our clients who are using LCBP don’t have to worry as much about many factors that will concern others, such as exclusion limits—although they might have to make some changes as families grow and shrink. We believe it is far better and safer to set up flexible estate plans that will survive changing circumstances than to set up a fixed-in-stone type estate plan and pretend you are going to review it every couple of years. And let’s face it, situations can change overnight, and you may not have the luxury of a time window to make important changes.
Congress, of course, is responsible for much uncertainty on the tax front. Between 2010 and 2015, they have established Applicable Exclusion Amounts (the amount that you can die with before you incur federal estate tax) that range from zero to over $5 million.The shifting target of the Applicable Exclusion Amount creates chaos for the estate planner. Traditional estate planners who do not use disclaimer-type planning will be forced to revise your will, trust, and beneficiary designations every year if they expect to achieve optimal results, because the dollar amount they need to worry about changes every year. (Of course, perhaps the traditional planner should not complain. All this revising brings in lots of revenue)! The shifting Applicable Exclusion Amount could have been called “The Estate Planners’ Full Employment Act” because it creates a steady need for redrafting and tinkering with the estate plan.
The shifting Applicable
Exclusion Amount
could have been called
“The Estate Planners’
Full Employment Act”
because it creates a
steady need
for redrafting and
tinkering with the
estate plan.
The use of disclaimers in estate plans is controversial. But there is a rapidly growing group of attorneys, with me leading the charge, who love using at least some form of disclaimer in the estate plans of most of their clients. I have been using them in my practice since the early nineties and in the vast majority of my cases, they have worked out very well. We always provide or over provide for the surviving spouse. But if there is money left over after that, why not take advantage of the enormous tax and other life-style benefits mentioned earlier or at a minimum set up your estate to make those decisions later. So I believe in them for the reasons stated here. To be fair, however, the majority of estate attorneys don’t use disclaimers in their practice. I could be glib and say that is because many estate attorneys haven’t considered the advantages of using disclaimers, which, at least for some attorneys, is unfortunately true. There are, however, a significant number of estate attorneys who fear that the surviving spouse will screw everything up by failing to disclaim the inheritance. These attorneys believe it is better not to give the surviving spouse any choices. I obviously disagree. I think for many families, giving the surviving spouse as many options as possible is a sound course of action.
Full disclosure however, I must report one situation that I handled, where the disclaimer didn’t work out. The estate attorneys who don’t typically use disclaimers can gloat after reading this story because it validates their fears.
I drafted a cascading beneficiary plan known as Lange’s Cascading beneficiary Plan™ (LCBP --more fully discussed in Chapter 15) for clients with $3 million in the husband’s IRA. Other than a modest house, that was the only significant asset in the estate. When I heard about my client’s death, it saddened me as I generally like my clients. The good thing was the surviving spouse was set up just the way I wanted with LCBP.
This event happened when the Applicable Exclusion Amount was only $1 million. For some odd reason, I often remember the general holdings and configurations of my clients’ estate plans. This family, as are many of my clients, was better at saving than spending. They lived a relatively frugal lifestyle and spent less than $60,000 a year. They also received Social Security.
As soon as I learned of his death, I remembered his holdings and knew what the best course of action would be. My plan was to recommend that his spouse disclaim $1 million to the secondary beneficiaries (their children and grandchildren) and keep the rest.
It would have worked out beautifully, but despite my best efforts, the surviving spouse insisted on keeping the entire IRA, but she did not change her frugal spending habits, so now her estate is worth well over $5 million and still growing. The result of her failure to disclaim when she could have will likely cost her children unnecessary estate taxes when she dies, and they may very well be too old to fully enjoy the money when they finally do inherit it.
The moral of the story is that there is a genuine risk of the surviving spouse refusing to disclaim when he or she should.
Personally, I feel the advantages of disclaimers far outweigh the disadvantages, but I believe that my job is to educate my clients about their options and have them decide what is best for them. The majority of my clients, perhaps due in part to my bias, have chosen to use disclaimers as part of a more flexible plan, instead of the traditional plan. I believe that if you have a long-term traditional marriage, the LCBP should be the starting point because adjustments can be made if needed. Disclaimers can also be used quite effectively in planning for non-traditional relationships. No matter what the relationship, however, the spouses/partners involved must trust each other in order to make disclaimers work as planned.
The decision of whether the surviving spouse should keep all the funds or whether the children should receive some portion of them (not to mention other possible options) can be most effectively made if the survivor is in possession of current facts and figures. We continually refer to the importance of “running the numbers” and after the death of the first spouse is definitely a great time to “run the numbers.” Properly drafted documents and beneficiary designations using disclaimers can provide the surviving spouse with enormous wealth building options after the death of the first spouse.
The Problem of Estate Planning in a Nutshell
With little fanfare or public discussion, Congress enacted two changes that can make estate planning documents that were created prior to 2010 completely obsolete, or, worse yet, potentially catastrophic for the surviving spouse. When the Applicable Exclusion Amount was less than $1 million, many couples established wills that included A/B trusts. With the enactment of the Taxpayer Relief Act of 2012, an Applicable Exclusion Amount of $5 million (adjusted annually for inflation) per person was made permanent. In 2012, you and your spouse could each leave $5 million without being subject to federal estate tax. In addition, the executors of estates of decedents dying on or after January 1, 2011 could elect to transfer any unused estate tax exclusion (called the Deceased Spouse’s Unused Exclusion Amount, or DSUEA), to the surviving spouse. This concept, known as portability, meant that a married couple could pass up to $10 million to their heirs without having to worry about federal estate tax. In 2015, that inflation-adjusted number is $5.43 million per person, or $10.86 million per married couple.
So what is the problem? The problem is that most married couples are not likely to have to worry about estate taxes any more, and their A/B trusts are unnecessary. And if your own estate planning documents contain certain language that is commonly used in wills, the executor of your estate could be forced to transfer an amount up to the Applicable Exclusion Amount – in 2015, that’s $5.43 million – in to your B trust. That might not be a problem if you are leaving an estate of $15 million, but if you are leaving an estate of
$2 million, that means that all of your money will go into the trust and your spouse’s access to the money will be controlled entirely by the terms of the trust. And the terms of the trust, if written at a time when it was expected to shelter far less money than it would today, may be far too restrictive to meet your surviving spouse’s income and “fun” needs.
Another problem can exist if your beneficiaries have financial problems that cause them to file bankruptcy. In 2014, the Supreme Court ruled that Inherited IRAs are not a protected asset in bankruptcy proceedings. In the past, parents generally did not have to worry about their children’s creditors before naming them as the beneficiaries of their retirement plans. This new ruling means that retirement money left outright to children is now considered fair game to a creditor, and in the absence of alternate planning, some children may never see a dime of their parent’s legacies.
And what if Congress does eliminate the stretch IRA? As I demonstrated in earlier chapters, the ability to allow your IRA or retirement account to continue to grow by limiting withdrawals to the required minimums makes a tremendous difference in what will serve your family best. There are some possible alternatives to the Stretch IRA, but if the provisions for those alternatives do not exist in your estate planning documents, then your family can lose some of the options to fund the additional income taxes that will be due on the IRA.
The problem, of course, is that there are many variables, and we cannot predict which ones will be relevant at the time of death. How much money will there be at the first death? Who will die first? What tax laws will be operative in the year of the first death? What will the needs of the surviving spouse be? Are you adding to the problem by hanging on to estate planning documents that are no longer relevant? Now that we understand the problem, what is the solution? The answer lies in the next chapter even though we have mentioned a few hints along the way.
A Key Lesson from This Chapter
It is extremely difficult to make a plan that will survive all foreseeable and unforeseeable events, but it is to your heirs’ benefit to set up your plan so that it is as flexible as possible.