3 Strategies to Consider When Sole Beneficiaries Want to Share the Wealth

I hear this story a few times each year: Uncle (or grandparent, sibling, or parent) died leaving his IRA to one named niece (or grandchild, sibling, or child). But everyone, including the named beneficiary, agrees--the decedent should have named all members of the class as equal beneficiaries. After all, he left all his other assets equally to all the class members. Surely he meant for all of them to share the IRA equally too, right? Can't we just ignore this mistake and pay out the IRA to everybody?

Unfortunately, what seems like an easy fix has to clear several hurdles, including the IRA administrator's policies, income tax consequences, transfer tax consequences, and the terms of the decedent's will.

Let's walk through an example. Uncle Liam died leaving his IRA to his niece, Sandy. His will leaves all his other assets equally to all three of his nieces: Sandy, Carol, and Caitlyn. The three nieces agree, the IRA should be shared equally, like the rest of the estate. But how can they get that result?

The Simplest Method The easiest way to take care of this would be for Sandy to keep the IRA, withdraw from it when she chooses (and as required by the minimum distribution rules), pay income tax on her withdrawals, and make cash gifts to the other nieces (either now or as she withdraws from the IRA) in an amount they all agree is fair. That would mean giving them each one third of the aftertax value of the IRA. This approach would not require any court proceedings or cause any conflict with the IRA provider.

This method has no income tax consequences, since Sandy will pay the other nieces only the aftertax value of the IRA distributions she receives. It does have a transfer tax consequence however: Sandy's transfers would be considered gifts for gift tax purposes, since she has no legal obligation to share the IRA with the other nieces. To the extent her transfer to any niece exceeds the annual exclusion amount in any year ($15,000 as of 2020), the excess will be using up some of Sandy's lifetime gift and estate tax exemption.

With the lifetime exemption now standing at $11.58 million per person, if Sandy is not an exceptionally wealthy person, she will have no concern about using up too much of it. Thus, this "quick and dirty" solution would probably work well for a not-too-large inherited IRA. However, if the IRA is large and/or if Sandy is wealthy enough to care about preserving her estate tax exemption (or concerned that the law may change and drop the exemption to a low-enough amount to affect her planning), she could try to keep her compensating transfers under the annual exclusion amount each year--or else consider one of the other solutions.

The Most Expensive Method: Reformation If there is evidence that the decedent made a mistake in filling out the beneficiary form, a state court-ordered reformation of the document may be appropriate. For example, if the nieces have witnesses who would testify that the decedent told them shortly before he died, "I am leaving all my assets equally to my three nieces," that could be evidence that he made a mistake in completing the beneficiary designation form for the IRA. Beneficiary designation forms are often filled out in haste and under pressure (for example, when rolling money over from your employer's plan upon retirement--when the retiree has dozens of forms to sign), and the forms are rarely reviewed by the IRA owner's estate planning lawyer, so mistakes are common.

If there is solid evidence that an error was made, the state court would order the IRA provider to pay the IRA to all three nieces, and the IRS would probably accept the result. By accepting the result, the IRS would agree that the nieces should be equally responsible for their respective shares of income tax on the IRA and for taking required distributions, and that no taxable gift occurred.

However, the IRS is not legally bound by a lower state court's order. The IRS is quite familiar with (and always rejects the results of) a "collusive" state court action, where the local probate court rubber stamps a settlement requested by family members who all agree with each other. Thus, if there is no actual evidence that the form was filled out erroneously, reformation definitely will not be accepted by the IRS. And if the reformation is based on evidence, the parties may want the tax results confirmed by an IRS private letter ruling--an expensive and time-consuming process.

Middle Ground: Disclaimer The final possible fix is a qualified disclaimer. Sandy would "disclaim" two thirds of the IRA (and keep one third). A qualified disclaimer (made within nine months after her uncle's death) would be effective to shift two thirds of the IRA (and its attendant income tax burden) away from Sandy without gift tax consequences. A qualified disclaimer involves a legal fee but no court proceedings or IRS ruling, normally, so it can be fairly simple and cost-effective.

But there can be a problem even here. When Sandy disclaims two thirds of the IRA, that does not mean the disclaimed share of the IRA automatically goes to the other nieces. Instead the disclaimed portion of the IRA will pass to the "contingent beneficiary" under the IRA beneficiary designation form. Thus, "where it goes next" needs to be carefully investigated before Sandy signs a disclaimer.

Assume (as is often the case) that there is no contingent beneficiary named by the uncle. In that case, the disclaimed portion will pass to the "default beneficiary" named in the IRA provider's plan documents--usually the decedent's probate estate. If the disclaimed portion of the IRA passes to the uncle's estate, and Sandy is a one-third beneficiary of the estate, Sandy will also have to disclaim her estate-derived share of the IRA. So, preparing a qualified disclaimer often involves disclaiming both the IRA (as beneficiary) and any share of the disclaimed asset that otherwise would pass to the disclaimant through the estate. And if the estate pours over to a trust of which Sandy is also a beneficiary, the disclaimer will need to cover her trust-derived share of the IRA, too. So even a "simple disclaimer" can be complicated.

Note that even if Sandy disclaims two thirds of the IRA so that it effectively passes to her cousins through the estate (and trust, if established), the other nieces will not get as favorable income tax treatment as Sandy. Sandy inherits her share as "designated beneficiary" (entitled, normally, to a 10-year payout) while an estate (our assumed default beneficiary), which is not a "designated beneficiary," cannot qualify for that.

Conclusion: You can fix these situations, but there is no one path that is simple, cheap, and tax-advantaged.

Natalie Choate is an estate planning lawyer in Boston with Nutter McClennen & Fish LLP. Her practice is limited to consulting regarding retirement benefits. The new 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is now available through her website, www.ataxplan.com, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article may or may not reflect the views of Morningstar.