How to Disclaim an Inherited IRA

Rose dies, leaving her IRA to her daughter, Lily, as named beneficiary. The contingent beneficiaries named on the IRA beneficiary designation form (to inherit the IRA if Lily does not survive Rose) are Lily’s children, Daisy and Iris. If Lily “disclaims” the IRA, it will pass to Daisy and Iris as if Lily had predeceased Rose. A disclaimer is a refusal to accept a gift or inheritance.

Wait a minute. Why isn’t that a gift from Lily to her children? After all, Lily was legally, morally, and every other way entitled to full ownership of that IRA when Rose died. She voluntarily gave up her right to ownership of this asset in order to benefit her children. That looks like a gift, right?

The IRS would have liked to tax Lily’s action as a taxable gift, and once upon a time, they tried to do that, but over many years, court after court ruled against the IRS. The courts said a “disclaimer” is not a gift because you can’t give away something you never owned. Accepting the inevitable, Congress enacted U.S. Code section 2518, providing that a “qualified disclaimer” would not be treated as a gift.

7 Tests of a Qualified Disclaimer

If your client wants to disclaim an inherited IRA, the disclaimer needs to be “qualified” to avoid gift tax consequences. To be “qualified,” the disclaimer must meet these seven tests:

• The disclaimer must be unconditional. Lily can’t say, “I disclaim on condition that Daisy and Iris put the money into irrevocable trusts,” or “on condition that I have enough left over for my living expenses.” She just gives up her rights without attaching conditions to her disclaimer.
• The person making the disclaimer (the “disclaimant”) must not have “accepted” the property. If Lily pays some of her bills out of the inherited IRA, or changes some of the investments inside the account, she has acted as an owner of the IRA. That’s inconsistent with “refusing to accept” the IRA. There are some actions that will not preclude a later disclaimer, and sometimes an action could be deemed just a “partial” acceptance, allowing Lily to disclaim the rest of the account. But if Lily is considering disclaiming, she should not do anything with this inherited IRA or its assets without first clearing the proposed action with her lawyer.
• The disclaimed property must pass, as a result of the disclaimer, to someone other than the disclaimant. For example, if the contingent beneficiary of Rose’s IRA were a trust of which Lily is a beneficiary, Lily’s disclaimer would not be qualified because the property is coming right back to her via another avenue. This condition does not apply to disclaimers by the decedent’s surviving spouse. But for Lily, she needs to make sure, before disclaiming, that the IRA is not coming back to her—for example, through a trust as contingent beneficiary.
• The disclaimer must be valid under state law. Again, work with the lawyer to get the disclaimer done.
• The disclaimer must be in writing and delivered to the person or entity who is holding the property (in this case the IRA provider) within nine months after the death of the original transferor (Rose, in this example). (If the disclaimant is under age 21, the nine-month deadline starts running when they reach age 21.) Because there is no mechanism for extending this deadline, it must be strictly adhered to.
• The disclaimant cannot accept consideration in return for the disclaimer. If Daisy and Iris say, “Lily, if you disclaim the IRA, we’ll make sure you don’t run out of money later,” and Lily accepts the deal, it’s not a qualified disclaimer. If Lily disclaims the IRA without making any prior deal with Daisy and Iris, nothing prevents them from later showing their gratitude in some financial way.
• Finally, the disclaimed property must pass, as a result of the disclaimer, to whomever it passes to without direction by the disclaimant. In other words, the disclaimant cannot choose who will get the property as a result of the disclaimer. Maybe Lily would like to say, “I’ll disclaim it all to Daisy because she’s poor and Iris is rich,” but she can’t do that.

In Lily’s case, her disclaimer would cause the IRA to pass outright to Daisy and Iris as Rose’s contingent beneficiaries, so there is no problem with this last requirement. If the contingent beneficiary of Rose’s IRA were a trust of which Lily was trustee, and if as trustee Lily would have discretion to determine who the funds would be paid to, the disclaimer would not be qualified (unless Lily also disclaimed those fiduciary powers). However, if the trustee’s power is limited to an ascertainable standard (such as “distributions needed for health and support”), the power would not violate this rule.

Code section 2518, as noted, decrees that a disclaimer meeting those conditions will not be treated as a gift for gift tax purposes. The code doesn’t say anything about income taxes, however. Fortunately, the IRS closed this gap by confirming that a qualified disclaimer of an inherited retirement benefit would not be treated as a “transfer” of that benefit for income tax purposes. Thus, Daisy and Iris will be treated as the IRA beneficiaries for income tax purposes as a result of Lily’s qualified disclaimer.

The income tax treatment is an important detail—some clients may say, “I don’t care whether my disclaimer is technically ‘qualified’ or not because my estate is way below the estate-taxable level, so I don’t mind making a taxable gift.” Fine. A nonqualified disclaimer causes no transfer tax problems in that case, BUT it may cause an income tax problem! The disclaimer could be considered a taxable sale of the IRA for income tax purposes.

After clearing all the “qualified disclaimer” hurdles, Lily is still not done with tax considerations: Iris and Daisy are grandchildren of the deceased IRA owner Rose. Lily’s disclaimer causes the transfer to be a “generation skipping transfer,” or GST, (from Rose to her grandchildren) potentially subject to the federal GST tax. Chapter 13 of the Internal Revenue Code imposes a tax on transfers that skip a generation (over and above regular estate and gift taxes). If Rose’s estate was large enough to exceed the exemption levels (over $12 million as of 2022), Lily may not want to do a disclaimer and trigger this tax.

Why Would Someone Want to Disclaim?

Working with her lawyer, Lily manages to clear all these hurdles and carry out a successful qualified disclaimer of Rose’s IRA. Leaving us with one more question: Why do people want to disclaim inherited assets anyway? There are several possible motives:

• Limit disclaimant’s taxes. Maybe Lily is already wealthy and worried about the estate taxes that will be payable on her death. She doesn’t need the money from Rose’s IRA, and the last thing she wants is to increase her own taxable estate with unneeded assets. She may also conclude that her children will be in lower-income tax brackets (with respect to future IRA distributions) than she is subject to. By disclaiming, she benefits her children without incurring any estate or gift tax on the transaction, and may be reducing the overall income tax hit to the IRA.
• Frustrate creditors. Some heirs may wish to disclaim because they fear they are going to be sued or they are overloaded with debt and heading for bankruptcy. They think by disclaiming they can keep this inherited asset in the family and away from their creditors. Does that work? Federal bankruptcy law and state law may prevent this use of a disclaimer. The disclaimant needs to consult a specialist for advice if this is the motive.
• Fairness among the family. Sometimes, a beneficiary disclaims in order to allow other family members to inherit the asset because the original beneficiary believes the decedent’s estate plan was unfair or unintentionally omitted some heirs. In my experience, it is unusual but not unheard of for a disclaimer to work to fix this kind of problem. For example, suppose Papa died leaving IRA to Child #1, omitting Children #2 and #3. The siblings believe that Papa intended to benefit them all equally but just didn’t fill out the form right. Unfortunately, if Child #1 disclaims two thirds of the IRA, that will not automatically cause the disclaimed portion to pass to the other children. Instead, the disclaimed portion will pass to the “contingent beneficiary” or even the “default beneficiary” under the IRA agreement, which would not fix the problem. The inheritor must figure out where the money will go before disclaiming for this reason (and consider other legal paths, such as reformation of the beneficiary designation if it contains mistakes). Unfortunately, there may be no way to “even things up” other than just accepting the IRA and making gifts to the omitted beneficiaries.
• Not sure of best outcome during the planning stage. Sometimes, the possibility of disclaimer is built into the estate plan, because the client and advisors don’t know what the best plan will be once the client dies. A common example is to leave an asset outright to the surviving spouse, with the idea that she will disclaim the asset and let it pass to a trust instead, if that plan appears better at the time of the first spouse’s death. However, it’s not unheard of for the actual named beneficiary to lose all interest in disclaiming the inheritance when the time comes, no matter how firmly everybody agreed on this plan when it was written.

As you can see, a disclaimer is not a simple matter. It’s a very useful tool in certain situations but not an easy cure-all. The better approach is to create the best estate plan in the first place and not have to rely on possible future disclaimers to cure foreseeable problems.