Fixing An IRA With The “Wrong” Beneficiary

Quite often, for many different reasons (often known only to the deceased original owner), the original owner of an IRA designates a beneficiary that the survivors don’t necessarily agree with. It might be that only one of several children is designated, or perhaps additional beneficiaries are designated along with a spouse.  In cases like these, there are ways to make changes to the outcome of the inheritance.  In this article we specifically deal with the case where only one of four children was designated as the primary beneficiary of the IRA.

To resolve the situation, let’s consider the following IRA: John, the decedent, designated April (his daughter) as the primary beneficiary of his IRA.  It isn’t known why John only designated April as the beneficiary, as he has three other children – Bill, Chuck, and Dale – and John had only his IRA as an asset to pass along to the children.  April could choose to take the entire IRA as her own and receive payments over her lifetime using the stretch rules, but she sees the inherent lack of fairness in the situation, so she wants to make the IRA available to her brothers as well.

One way to accomplish this would be for April to withdraw 75% of the IRA and split that amount with her brothers.  She would then be able to stretch out the payments on the remaining 25% over her lifetime.  Mission accomplished, right?

The problem with this option is that April would have to pay tax on the 75% distribution – and since the IRA is sizeable, this is a significant cost.  Naturally she could just pass along this tax cost to her brothers in the form of a reduced payment, but this isn’t a very efficient way to distribute the money.

On the other hand, April could maintain the account in her name and stretch out payments over her lifetime, splitting each payment (after tax) among herself and her brothers.  Again, this accomplishes what she had set out to do, but she’s still paying tax on the entire amount and since our tax system works on a graduated scale, the tax on 100% received by one person is likely to be much higher than the tax would be for four persons each receiving 25% from the account.  In addition, the three brothers would be required to wait until April decides to take a distribution before they would have access to the account.  Bill for example, would prefer to withdraw a large sum right away as he’s building a home and could use the funds for the construction.  This would be very inefficient (tax-wise) if April had to make the withdrawal for him and pay the tax at her higher rate.

So – what else could be done?  It would be great if there was a way for April to re-write the beneficiary designation so that all four children were considered to be the beneficiaries, but that’s not possible.  What is possible is to re-direct a portion of the inheritance, by way of a method called disclaiming.

It’s important to know how to properly disclaim the inheritance of an IRA.  The person disclaiming all or a portion of an IRA must not be an eventual beneficiary as a result of the disclaimer.   Plus, the person disclaiming must not be in a position to direct who are the new beneficiaries; the natural course of the law must be followed.  If either of these rules is broken, the disclaimer is considered to be nonqualified, and any distribution would be considered to have been done by April.  Any amount transferred to her brothers would be considered a gift, subject to gift taxes.

So, if April disclaims the entire IRA, the new beneficiary would be John’s estate.  Since John’s will dictates that the four children will split all of his assets equally, this would accomplish the desired result, right?  No, not really.

The problem is that, when April disclaims the entire IRA, she is still an eventual beneficiary of the IRA since the estate becomes the de facto beneficiary, breaking the first rule above.  In addition, since the estate isn’t a “person”, the stretch rules can’t be used for this IRA at all.  When there is no real person as a beneficiary of an IRA, the entire account must be paid out within five years, rather than stretched out over a beneficiary’s lifetime.

What April should do is to disclaim 75% of the IRA, and also disclaim rights to the IRA portion of the estate that results from her first disclaimer.  This gives her 25% of the original IRA with the stretch benefits still intact.  In addition, since she’s disclaimed her right to the estate portion of the IRA asset, her brothers each have right to 25% of the IRA – 1/3 each of the 75% that April disclaimed.  This portion passes through the estate to the brothers.

The brothers will not be allowed to stretch out their payments from the account for more than five years – this is one unfortunate circumstance that can’t be avoided.  But otherwise, the eventual distribution is much more “fair” – even if it’s not what John had planned.  And each brother has control over his portion of the funds, at least for distribution purposes.  Bill can take the large distribution right away, and Chuck and Dale can delay up to five years before taking a distribution.  And each of the four siblings will only pay tax on the distribution that he or she takes.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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