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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.

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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