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Retirement Perspectives

Forget the old idiom about looking a gift horse in the mouth: If someone dies and leaves you an IRA or 401(k), it may be OK to say, "no way."

The idea of disclaiming an inheritance may sound strange at first. Why in the world would someone refuse an inheritance? Good question.

Federal tax law recognizes an individual cannot be forced to accept an inheritance. So, if a primary beneficiary inherits an IRA or qualified plan, that individual has the option to disclaim the inheritance under IRC Section 2518(b), which is the formal and irrevocable refusal to accept a gift or inheritance at the death of the account owner.

Technically speaking, Section 2518 addresses when a deceased IRA account owner leaves an account to an “undesirable beneficiary” (someone who was not intended to receive the assets). If the rejected bequest is executed correctly, the disclaimant will be treated as having predeceased the primary beneficiary. In that case, the inheritance would be passed directly to the contingent beneficiary.

The contingent beneficiary is the individual who would have been entitled to the benefits if the disclaimant had predeceased the participant. When a beneficiary elects to disclaim inherited retirement funds, the funds then will pass directly to the next beneficiary entitled to receive the funds. More important, the inheritance would not be considered a taxable gift to the disclaimant.  

Disclaimers commonly are used as part of an estate plan and or tax planning. For example, older beneficiaries could consider disclaiming so that they would remain eligible for government benefits, tax deductions, or credits that are means tested. Disclaimers also can play a vital role for those beneficiaries that rely on Medicaid; avoid taxation of social security benefits and the 3.8% net investment income surtax.

An often overlooked benefit is that a qualified disclaimer serves as a tax-free gift between the disclaimant and contingent beneficiary. Disclaiming can be an attractive strategy when the named beneficiary at the time of the IRA owner’s death does not need the funds from the account, or is significantly older than the contingent beneficiary. A qualified disclaimer thus would allow a lengthened “stretch” payout based on the much younger contingent beneficiary’s life expectancy.

For example, a parent could disclaim, thereby enabling the account to pass directly to their children or grandchildren (assuming they were the named contingent beneficiary). Now, the younger beneficiary has a longer payout period with the “stretch,” or, if needed, he or she can take a distribution to pay for higher education, a first home, or another big-ticket item.

But beware: since a qualified disclaimer is irrevocable, executing a qualified disclaimer is not always an simple straightforward decision. We recommend partnering with a knowledgeable tax professional and/or estate attorney familiar with the many applicable rules.

A number of post-death conditions must be satisfied for the primary beneficiary to carry out a “qualified disclaimer”:

  1. Besides being irrevocable, refusal must be unconditional and in writing. Disclaimers generally come in one of three forms: 1) full disclaimer, 2) dollar amount, or 3) partial (fractional).
  2. A disclaimer must be received by the IRA custodian within nine months of the owner’s death.   Notably, if the disclaiming beneficiary is under age 21, the deadline is extended to nine months after reaching age 21. Contact the IRA custodian or plan sponsor to familiarize yourself with their disclaiming process.
  3. The individual doing the disclaiming must not have “accepted” interest in the account. Notably, a beneficiary can receive the required minimum distribution (RMD) from the decedent’s IRA for the year of the death without the distribution being considered “acceptance” of the account. If the deemed beneficiary distributes more than just the RMD (for the year of death), such excess may be deemed acceptance.
  4. The disclaimant is prohibited from directing the inheritance to a specific individual. Instead, the inheritance generally will pass to the individual who would have been entitled to the benefits if the disclaimant had predeceased the participant.

Disclaimer Example:

  • Joe, age 74, died on February 28, 2017, with an IRA valued at $400,000.
  • Joe did not take his RMD before passing. His 2017 RMD was $20,000.
  • Joe had named his spouse Jill as the sole primary beneficiary, and his son Robert (age 44) as the contingent beneficiary.
  • Jill took Joe’s 2017 RMD of $20,000.
  • After taking the RMD, Jill delivered a qualified disclaimer to the IRA custodian within nine months of Joe’s death.
  • The rest of the IRA passed directly to Robert, who then would be able to stretch payouts from the inherited IRA over his life expectancy.

What Happens If a Contingent Beneficiary Was Not Named?
If a contingent beneficiary is not named (this is a common occurrence), the account (e.g., IRA, 401k, etc.) would pass to the individual based on the language in plan document or IRA custodial agreement, which could, however, create a situation that does not meet the decedent’s wishes. In other words, the account may be inherited by someone other than the intended beneficiary. So, be sure to investigate who would receive the inheritance as result of a disclaimer. Remember that the disclaimant cannot specify or control how the account passes.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

Qualified Retirement Plan—This is a savings plan that is allowed certain tax advantages because it meets criteria spelled out in the IRS Code and in the Employee Retirement Income Security Act [ERISA] of 1974. Employers can take tax deductions for any contributions they make to an employee's account. Employee contributions and investment returns are tax-deferred until withdrawn. Contribution limits apply, as do penalties for early withdrawal.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

Required minimum distribution (RMD) is the minimum amount you must withdraw from your account each year. You generally have to start taking withdrawals from your IRA, SEP IRA, SIMPLE IRA, or retirement plan account when you reach age 70½. Roth IRAs do not require withdrawals until after the death of the owner.

An IRA rollover may involve the application of fees and charges to the investor. A rollover is the process of moving your retirement savings from your retirement plan at work (401(k), profit-sharing plan, etc.) into an Individual Retirement Account (IRA). 

The Summary Plan Description (SPD) issued by plan administrators explains participants’ and beneficiaries’ rights, benefits, and responsibilities under the plan in understandable language. The SPD includes such information as: the plan’s requirements regarding eligibility; a description of benefits and when participants have a right to those benefits; procedures regarding claims for benefits and remedies for disputing denied claims; and the rights available to plan participants under the Employee Retirement Income Security Act (ERISA).

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