When Beneficiaries Don't Like the Plan

By Natalie Choate

Question: A mother died, leaving her $400,000 house equally to her son and daughter, but only the son was named as beneficiary on the mother's $400,000 IRA. The children don't know whether the mother intended this unequal treatment, but they want to equalize their inheritances. The son proposes to assign half of the inherited IRA to the daughter to accomplish this result. Would that work, or would that be treated as a taxable distribution of the account?

Answer: Assigning an inherited IRA to another person would cause the assigned portion (or possibly the entire account) to lose its status as an IRA and be deemed distributed. Furthermore, under our Tax Code, "doing the right thing," as the son proposes to do, is not regarded as a benign benevolence--it triggers a gift tax! The son's $200,000 transfer to the daughter would be deemed a taxable gift.

Between income taxes and gift taxes, this would be a costly move. Let's review other options and see if there is another way to accomplish the children's goal with less drastic tax consequences.

Reformation

It would be worth investigating to determine whether the mother really intended to leave the IRA only to her son or whether she intended to leave it equally, but was thwarted by perhaps someone drafting the beneficiary designation form incorrectly. Perhaps the mother believed that the form she signed left the account equally and did not realize that it named only one of the children. This type of mistake can happen easily, for example, when the account is being moved from one IRA provider to another, especially if it happened at a time when the mother was sick, traveling, or otherwise preoccupied. If there is strong evidence of such a "scrivener's error" (mistake by the professional who drafted the beneficiary designation form), the state probate court should agree to "reform" (rewrite) the beneficiary-designation form to say what it was supposed to say.

A valid state-court-ordered reformation would probably convince the IRS that the IRA really belonged equally to the two children. But reformation is probably  a long shot here. It's hard to get the professionals to admit they made an error, and court proceedings are expensive and time-consuming.

Disclaimer

When it appears that the documents were correct and were validly signed, and the mother knew exactly what she was doing, but the beneficiaries just don't like the outcome, consider a disclaimer. A beneficiary cannot be forced to accept an inheritance. Check who is the contingent beneficiary of the IRA because that is who would inherit any portion of the IRA that the son disclaims. If the daughter is the contingent beneficiary, then a disclaimer is the best option: The son accepts only half of the IRA and disclaims the other half, and the disclaimed half passes to the daughter.

A qualified disclaimer would not be treated as a gift from the son to the daughter, nor would it trigger income tax on the IRA. The daughter would take over half the IRA just as if she had been named as 50% beneficiary in the first place. There would be no negative income or gift tax consequences; the IRA would stay in existence.

However, if the daughter is not the contingent beneficiary of the account, a disclaimer would not be such an easy way out and might even be impossible. For example, if the son's children are the contingent beneficiaries, there is no way to get the disclaimed half interest over to the daughter unless the son's children also disclaim. And if they are minors, that might require appointment of a legal guardian who in turn probably would not agree to a disclaimer on their behalf.

If the contingent beneficiary were mother's estate, the son's disclaimer would cause his half of the IRA to pass to the mother's estate, which would accelerate the income taxation of the asset (because an estate cannot qualify for a life-expectancy payout). Even then the asset still won't pass to the daughter unless she is the sole beneficiary of the estate, or unless the other beneficiaries (including the son if applicable) disclaim this asset so they don't inherit it through the estate. The estate scenario, even if doable, is cumbersome, but at least it avoids the son's making a taxable gift.

If reformation looks like a dead end, and a disclaimer won't work because, for example, minor children would step in to inherit as contingent beneficiaries, then the son and daughter have to face the fact that there is no easy way to equalize their inheritances. Still, assigning half the IRA to the daughter would not be the way to go. It would be better for the son to cash out half the IRA and give his sister the net cash (after deducting the income taxes he has to pay on the cash-out). At least the favorable tax treatment of his own half of the IRA would not be jeopardized, and the gift tax burden is lower (because the gifted amount is smaller).

Alternatively, the son could just plan on taking distributions from the IRA over a number of years to finance annual gifts to his sister that would be within the gift tax annual exclusion amount (currently $14,000), and continue this gift program annually until he thinks the total gifted amount represents fair compensation for the mother's unequal treatment of the siblings.

Resources: For full details on qualified disclaimers of retirement benefits, see Chapter 4.4 of Natalie Choate's book Life and Death Planning for Retirement Benefits . 

The views expressed are the author's.