"Tiny" mistakes that can cost your heirs a fortune

If you intend to refuse an inheritance—which you may have good reason to do—watch out for these inadvertent missteps.

By Brad Burg
Senior Editor

What—reject a bequest? We're kidding, right? Who'd want to turn down money or other property inherited from a loved one's estate? But on occasion, just saying No can be a good idea, whether to save your heirs taxes, to let the property pass to someone who needs it more, or to shelter the inherited assets against a court judgment or hungry creditors.

You might not even have to give up the inheritance entirely. You could "disclaim" it, as lawyers say, and let it pass to a trust that benefits the kids and you. And you can help direct the trust, if you choose.

As we'll see later, such an arrangement worked out well for a New York internist, who was about to accept an inheritance from his recently deceased spouse—a move that would have cost his children $200,000 in taxes, says Gideon Rothschild, a Manhattan attorney. "Luckily, he consulted us first," Rothschild says. "To help fix things, he simply had to sign a couple of disclaimer forms."

A Delaware widow wasn't so lucky. She was upset that her husband hadn't left certain property to their sons—and more distressed to find she could have done so herself, if only she'd known a key disclaimer rule, says Mary Hickok, a trust attorney with Wilmington Trust, in Wilmington, DE. Hickok adds: "We also see surviving spouses who were advised not to disclaim inherited retirement plan money, often by the people who make fees managing those accounts but who wouldn't get to manage the funds after a disclaimer."

Even if you've completed your planning, it's not too late for your family to benefit from disclaimers. "You may not need to revise documents, but you should make sure family members understand the idea," says Los Angeles attorney James R. McDaniels. If you're reviewing your estate or retirement plan, considering disclaimers may help you recognize all the options. And if you've recently inherited or may do so soon, you should look into disclaimers immediately.

Here's what you need to know.

How a disclaimer lets you keep options open

The disclaimer lets an heir step aside in favor of whoever's next in line, to save taxes or for other reasons—like keeping the intended heir's creditors from seizing the inherited assets. In other words, it permits a family to make use of a Plan B, or even a Plan C or D. That flexibility may prove critical, because estate plans often don't keep up with changing laws or evolving family situations.

Partial disclaimers may be possible, too, depending on your estate and on the law in your state. "Here in Missouri, you can pick any percentage you want of certain assets," says Colleen Nemanick, an attorney in St. Louis. "You can also refuse specific assets—maybe you want your son to have the vacation home. Or you could disclaim everything except the vacation home. It's your call."

Such options may be useful even in families that have done thorough estate planning—or think they have—because the rules are full of treacherous traps.

One such trap almost caught Rothschild's internist client. The doctor and his wife thought they'd taken the necessary steps to minimize estate taxes for their children. They knew that currently you can leave up to $675,000 free of estate taxes to people besides your spouse (the amount will rise to $1 million by 2006), and they thought they'd arranged things so that each would leave behind enough assets to take full advantage of that break. Moreover, each had a carefully drawn will providing for that amount to go into trust for the kids and the surviving spouse.

So what went wrong? "Their planner hadn't realized that the way you own property can control how it's passed on," Rothschild says, "and most of the wife's assets weren't controlled by her will. She'd owned many of them jointly with the doctor. Also, her pension plan and insurance policy each named him as beneficiary. All of that would bypass the trust. It would pass directly to the doctor, and the proceeds would eventually go to his children in his taxable estate. It seemed his wife's chance to leave the children the full $675,000, with no estate tax, had been missed."

The internist was reluctantly about to take possession of those assets when he consulted Rothschild. "We told him to disclaim some of his inheritance, so that part would go into the trust," the lawyer recalls. "He was happy to find that this way, his wife's tax-free bequest wouldn't be jeopardized. And because he was also a beneficiary of the trust the assets went into, he could receive income from the trust—even principal, if he needed it. "

But doesn't disclaiming an asset mean giving up all rights to it? "Generally, yes," Rothschild says. "But spouses can get this unique break, when the heir next in line is a trust set up with proper wording. In fact, the beneficiary spouse can even be a co-trustee."

Reducing taxes is probably the most common reason to refuse an inheritance, but it's not the only one. "Suppose someone hasn't thought to leave a particular asset to one child who really wants it," says David Bray, a trust officer with Firstar Bank in St. Louis. "Or say your parents leave you money you don't need, and your children are the next beneficiaries named. Instead of accepting the cash, you might disclaim it and allow the kids to inherit it." The kids may be in a lower tax bracket as well, a second possible reason to let an inheritance pass you by.

Doctors have another motivation for learning about disclaimers: asset protection. "If you're concerned about exposing your wealth to creditors," Rothschild says, "you might disclaim an inheritance to protect it. Often, you can step aside even if a lawsuit's pending when the inheritance comes along. In fact, depending on state law, you may be able to do so even after a judgment comes down against you."

However, the tactic won't help you elude that creditor with the top hat and goatee. A disclaimer won't get you off the hook for taxes or other debts you already owe Uncle Sam.

Make sure your heirs know the rules in advance

"Once, a widow became tearful in my office after learning that she could have corrected omissions in her husband's will if she'd consulted me earlier," says Mary Hickok. The widow was particularly upset that a certain piece of real estate and some large investments didn't go to their two adult sons. Her husband had wanted to take care of those bequests, but he couldn't get to the lawyer before his death. Hickok had to tell the widow that she could have carried out his wishes by disclaimer, if she'd done so by the deadline—within nine months after her husband's death.

Such tales underscore a key point: The disclaimer can be a big help, but it comes with some traps of its own. For example, that nine-month cutoff is the same as the deadline for filing an estate tax return, Hickok notes. "That can be misleading, because that tax return might get an extension but the disclaimer deadline won't change," she points out.

Moreover, state law may require that the disclaimer be filed with the proper court before the nine-month cutoff. "During one new client's interview, we found that his disclaimer deadline would expire that day," recalls New York City attorney Martin Shenkman. "So his family's situation ultimately depended on crosstown traffic. We made it to court in time, but with just minutes to spare."

Worse, you can run afoul of disclaimer rules even sooner—in fact, immediately after someone dies—because you can inherit without knowing it, by accepting a benefit from an asset bequeathed to you. "Suppose you and your spouse own a joint money-market account," Shenkman says. "If you cash a check after your spouse dies, the law might say you've accepted the entire asset. I've seen clients stunned to find that because of a trivial transaction, they've lost their chance to refuse large assets, with terrible tax consequences." Adds Rothschild: "An automatic deposit—or even retitling a joint account into your own name—might mean you've accepted the bequest of your spouse's half."

So if you want to preserve your family's disclaimer options, better re-examine property you own jointly; you may need to make ownership changes to avoid problems. Also, alert your heirs to these disclaimer issues now, and remind them later by leaving an instruction letter to be opened immediately after your death.

Keep in mind, too, that although the disclaimer may seem to permit redoing an estate plan after the fact, it's a limited correction, not an open-ended revamping. An heir can step aside only for whoever is next in line, and can't choose who that person should be. "When you disclaim an asset, the law asks, 'Who would it go to if you were already dead?' " explains Colleen Nemanick. "Things proceed as though you weren't around."

That means you may need to plan ahead in detail. For instance, if your husband wants the option to disclaim certain assets in favor of a trust that would benefit him as well as the children, you must pave the way for that. "People often ask whether a disclaiming heir can set up a trust and disclaim in favor of it. I have to remind them that a disclaiming person, who's treated as if already deceased, is in no legal position to set up anything," says Nemanick.

New rules make disclaimers even more useful with retirement assets

Disclaimers have long been effective in passing on qualified plans and IRAs. Here's why: You're supposed to pick a beneficiary before you reach age 70 1/2, which is when withdrawals must start. Say you choose your spouse and name your son as next in line. Now suppose you die before that required beginning date. "If your spouse inherits, distributions will be based on his or her life expectancy," McDaniel says. "But if your spouse steps aside in favor of your son, distributions to him will be based on his longer life expectancy and will be stretched out, which is often what people want. Pulling money out of a nest egg faster than necessary means you risk depleting it."

What if you outlive that milestone age? Until recently, the plan's distributions would still have been based on the life expectancy of the spouse (or other beneficiary) you named before turning 70 1/2, even if that beneficiary were to step aside. The same rule held even if you changed beneficiary designations after age 70 1/2. For beneficiaries, that was often bad financial news: They might have to take the money out much faster than was economically desirable.

But because of new rules, the withdrawal rate for mandatory distributions no longer becomes fixed in stone at age 70 1/2 .* "Now," McDaniel explains, "the distribution will depend on the ages of those who inherit. So a disclaimer, besides keeping assets out of a parent's (or grandparent's) taxable estate, will also permit a slower distribution pattern that preserves assets longer."

Good news, but some other potential stumbling blocks remain. For one thing, you need to check what your plan itself permits when you're considering disclaimer possibilities, cautions Shenkman. Moreover, another helpful plan-distribution rule now gives your heirs until the end of the year after your death to determine who your plan's ultimate beneficiaries will be. But don't be confused: The disclaimer deadline is still nine months after your death.

Then what's the later deadline for? Say a plan has a charitable trust among its beneficiaries. That may force the plan to distribute all the money sooner—perhaps faster than the family heirs want to get it, McDaniel explains. Restructuring can avoid that, but it must be completed by the later date.

Get your spouse involved from the get-go

Probably the biggest threat to the use of a disclaimer is your spouse's attitude. As Shenkman notes, "The attorney is advising, 'Don't accept this $700,000 or so, and your heirs will save the estate tax on it. Great, no?' Well, maybe not, from the client's side of the desk." Even if those assets go into a trust with your spouse as a beneficiary and co-trustee, it's not the same as outright ownership.

Hickok concurs. "Persuading a spouse to disclaim substantial assets can be tough. And there's often a trusted money manager saying, 'Take it all; later you can help out the kids with annual tax-free gifts, which can save them about as much in taxes.' There are usually enough numbers to juggle so that taking the whole pot may look okay—even when it's not."

Hickok recommends a commonsense tactic: "Include your spouse in all the discussions about this, with your lawyer and with any corporate trustee involved." In fact, consider bringing other family members into the planning, too. Then review your plan to see where disclaimers might be useful—and think about mentioning the disclaimer option in the plan documents, to make sure heirs will remember when it counts.

Rothschild agrees: "When drafting wills today, I generally put in the possibility of disclaimers. Tax laws change, and so does the value of assets. The language can help ensure that the division of assets will be as flexible as possible, and that the best choices will be made when the time comes."

You may wonder whether much of this will become moot if Congress cuts back the estate tax. It won't. "In fact, given the increasing uncertainty about the estate laws, it's sensible to build in more flexibility," says David Bray. "Also, deciding who should inherit may involve income tax considerations, since heirs may be in different brackets—and no one's talking of eliminating those."

Estate planning also involves choosing which heirs should or shouldn't have financial control of their assets. That may require planning for trusts, which can involve disclaimers, too. So even if Uncle Sam decides to reduce estate taxes, disclaimers can play an important role in your loved ones' ultimate financial security.

*See "Your nest egg just got bigger," April 9, 2001.

 

Brad Burg. "Tiny" mistakes that can cost your heirs a fortune. Medical Economics 2001;10:92.