Can I Decline an Inherited IRA?

The rules governing inherited Individual Retirement Accounts (IRAs) have changed over the years. They have become even more complex since the passage of the original SECURE Act with the passage of SECURE 2.0. The inheritor of an IRA may be required to empty the account and pay taxes on the resulting income within 10 years. In some situations, beneficiaries might choose to execute a Qualified Disclaimer and avoid inheriting the IRA, according to a recent article, “How to Opt Out of Inheriting an IRA” from Think Advisor.

Paying taxes on the distributions could put a beneficiary into a higher tax bracket. In some situations, beneficiaries may want to execute a Qualified Disclaimer and avoid inheriting both the account and the tax consequences associated with the inheritance.  Sometimes clients would rather pass wealth to another person or later generation, and income producing assets such as IRAs are attractive options for that.

Individuals who use a Qualified Disclaimer are treated as if they never received the property at all. Of course, you don’t enjoy the benefits of the inheritance but don’t receive the tax bill.  See here for more on how disclaimers work.  https://galligan-law.com/can-you-refuse-an-inheritance-disclaimer/

Suppose the decedent’s estate is large enough to trigger the federal estate tax. In that case, generation-skipping transfer tax issues may come into play, depending on whether there are any contingent beneficiaries.

An experienced estate planning attorney is needed to ensure that the disclaimer satisfies all requirements and is treated as a Qualified Disclaimer. It must be in writing, and it must be irrevocable. It also needs to align with any state law requirements.

The person who wishes to disclaim the IRA must provide the IRA custodian or the plan administrator with written notice within nine months after the latter of two events: the original account owner’s death or the date the disclaiming party turns 21 years old. The disclaiming person must also execute the disclaimer before receiving the inherited IRA or any of the benefits associated with the property.

Once the disclaimer is made, the inherited IRA must pass to the remaining beneficiaries without the disclaiming party’s involvement.

This is very important, but the disclaiming party cannot decide who will receive their interests, such as directing the inherited IRA to go to their child. Instead, the asset goes to the next beneficiary as if the disclaimer passed away before the account holder.  If the disclaiming party’s child is already named as a beneficiary, their interest will be received as intended by that child.

The person inheriting the account must execute the disclaimer before receiving any benefits from the account. Even electing to take distributions will prevent the disclaimer from being effective, even if the person has not received any funds.

In some cases, you may be able to disclaim a portion of the inherited IRA. However, these are specific cases requiring the experience of an estate planning attorney.

Reference: Think Advisor (Feb. 8, 2024) “How to Opt Out of Inheriting an IRA”

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Taxes on Life Insurance?

When people purchase life insurance policies, they designate a beneficiary who will benefit from the policy’s proceeds. When the insured person dies, the policy’s beneficiary then receives a payout known as the death benefit.

Yahoo Finance’s recent article entitled “Will My Beneficiaries Pay Taxes on Life Insurance?” says the big advantage of buying a life insurance policy is that, upon death, your beneficiaries can get a substantial lump sum payment without taxation, unless the amount of the life insurance pushes your estate above the applicable federal estate tax exemption. In that case, your estate will need to pay the tax.

While death benefits are usually tax-free, there are a few situations where the beneficiary of a life insurance policy may have to pay taxes on the lump sum payout. When you earn income from interest, it’s typically taxable. Therefore, if the beneficiary decides to delay the payout instead of receiving it right away, the death benefit may continue to accumulate interest. The death benefit won’t be taxed. However, the beneficiary will typically pay taxes on the additional interest.

So, for example, if the decedent had an insurance policy with a $200,000 death benefit which pays to their daughter at death. The daughter submits a claim after the parent dies and receives $200,736. The $736 is interest generated on the amount of money held by the company post­ death until pay out. The death benefit of $200,000 is not taxable, but the $736 is income taxable as interest, just as though the beneficiary has held the $200,000 in a bank somewhere and generated $736 in interest.

Additionally, the value of the insurance policy is subject to estate tax in most cases. This is true for typical insurance policies where an individual owns a policy on their own life and the proceeds pay out at death (e.g. the $200,000 policy described above). The value of the insurance increases the size of your estate so that if your estate excludes your applicable gift and estate tax exclusion amount (currently about $13,000,000) then your estate will have estate tax to pay.

This obviously doesn’t affect too many people, but many term policies can dramatically increase estate sizes due to their high death benefits.  Some states also have their own inheritance or estate taxes to consider.

Estate planning attorneys, especially when the estate tax exemptions were lower, frequently used life insurance trusts, often called “ILITs” or “Irrevocable Life Insurance Trusts,” to combat this. As the estate tax exemption is currently expected to be cut in half in 2026, these kinds of trusts make sense to use now so that the value of the insurance is removed from your estate in anticipation of a lower exemption.  They work because the client doesn’t have ownership of the insurance policy. It is owned and maintained by the trust without any “incidences of ownership” so that the policy is not considered controlled by the decedent. They will often pay money to the trust which will in turn pay the insurance premiums during life.

I often recommend this to younger clients who are considering life insurance. They may never expect to be estate taxable, but as we don’t know what the future holds, or where politics will take us, we can remove the insurance from their estates now and so not worry about it.

If you want to know more about how life insurance impacts your estate plan, see this article:  https://galligan-law.com/role-of-insurance-in-estate-planning/

As a warning, I’m referring to taxation of life insurance at death. Transferring the policy, withdrawing money or taking a loan from the cash value and surrendering the policy can all have taxable components, so you would want to consult a CPA or attorney on the tax implications before proceeding.

To summarize, beneficiaries usually won’t have to pay taxes on life insurance proceeds. However, some situations can result in a taxable event and in some cases can be planned for in advance.

Reference: Yahoo Finance (Jan. 17, 2023) “Will My Beneficiaries Pay Taxes on Life Insurance?”

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Making a Gift on your Deathbed?

A new case out of Tax Court centers on the question of when a “deathbed gift” is complete for federal estate and gift tax purposes.  Clients make gifts to reduce the federal estate tax, or reduce it to a manageable size, especially as we draw closer to 2026 when the estate tax exemption will be a far lower number.

The two tax law provisions affecting this are described in the article “Tax Court Says When Deathbed Gifts Are Complete” from accounting WEB:

Annual gift tax exclusion. A taxpayer may give gifts to recipients under the annual gift tax exclusion without incurring any federal gift taxes. The exclusion, indexed for inflation in $1,000 increments, is $16,000 per recipient in 2022. It’s doubled to $32,000 for joint gifts made by a married couple. Estates can be reduced with planned use of the annual gift tax exclusion. For instance, if a taxpayer and a spouse give the maximum $16,000 to five relatives for five years in a row, they will have transferred $800,000 ($32,000 x 5 x 5) out of their estate, free of taxes.  This is enhanced when you make gifts of different assets that can be discounted in value.

Now, every time I write an article about gifting, I always temper it.  You’ll noticed from the next paragraph that the estate tax doesn’t apply to too many people, and so may not be advantageous.  It is also true that assets not in your estate at your death do not receive a step up in basis.  This applies to things like stock, real estate and many other non-cash items, which means gifting may ultimately increase the total tax to beneficiaries instead of reducing it.  So, it is worth discussing this with a professional before starting a gifting campaign.  See our website for a much broader approach to estate tax planning.  https://galligan-law.com/practice-areas/estate-tax-planning/  

Unified estate and gift tax exemption. In addition to the annual gift exemption, gifts may be sheltered from tax by the unified estate and gift tax exemption. As of this writing, the exemption is $10 million, indexed for inflation, which brings it to $12.06 million in 2022. It is scheduled to drop to $5 million, plus inflation indexing, in 2026.

Using the exemption during the taxpayer’s lifetime reduces the available estate shelter upon death. These two provisions give even very wealthy taxpayers a great deal of flexibility regarding liquid assets.

In the new case, Estate of DeMuth v. Comm’r, TC Memo 2022-72, 7/12/22, the agent under a power of attorney for a Pennsylvania resident made gifts of the annual gift tax exclusion on an annual basis from 2007 to 2014 to his siblings and other family members, in accordance with the POA.

The father’s health began to fail in 2015 and he passed away on September 11. On September 6, five days before he died, the son wrote eleven checks, totaling $464,000 from the father’s investment account.

Some recipients deposited the checks before the decedent’s death, but others did not. Only one check was paid by the investment account before the decedent’s death.

The question before the Tax Court: are the gifts complete and removed from the decedent’s estate?

According to the IRS, any checks deposited before death should be excluded from the taxable estate, but the Tax Court looked to the state’s law to determine the outcome of the other checks. The Tax Court ruled the checks not deposited in time must be included in the decedent’s taxable estate.

As a fun aside for our Pennsylvania friends, Pennsylvania also has inheritance tax, which attaches to transfers made within a year of death with a $3,000 exemption per recipient.  So, the estate would still have to pay inheritance tax on the completed transfers, although the inheritance tax rates are nothing compared to the federal estate tax rates.

The estate planning lesson to be learned? Timing matters. If checks are written as part of the plan to minimize taxes, they must be deposited promptly to ensure they will be considered as gifts and reduce the taxable estate.  In all cases, it is better to have, and execute, a plan of action before trying to resolve taxes on your deathbed.

Reference: accounting WEB (Aug. 26,2022) “Tax Court Says When Deathbed Gifts Are Complete”

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