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My father recently passed away and left me as executor of his estate. His intention was to leave my mother 50% of his estate and my sister and me 25% each. He had told us this verbally and also had it documented in his will.

However, the majority of his money is in three IRAs and all three of those have mom as the 100% beneficiary. She wants to grant his wishes, so I'm trying to figure out the best way to do so.

I talked with the attorney who did the will and she said that mom could cash out the IRAs without paying taxes and then gift 25% to each of us tax-free (the gifts would be significantly more than the $14,000 tax-free gift limit). I thought she was wrong on both accounts, and after doing some research it appears she was wrong, which may explain how dad got into this situation to begin with. He probably thought his money could get distributed to us tax free, which is how mom understood it would happen.

It appears the best approach here would be for mom to disclaim the IRAs, allow them to go to the estate, and then the three of us inherit the way dad had intended.

What would be the tax implications of this? When would the money be taxed? When the IRA is cashed out to the estate? If so, at what rate would it be taxed? Because it would be an inheritance we would not have to pay taxes on the inheritance, correct?

Is there a better option?

  • 6
    If you don't trust your attorney, find another one. Read the answers here to get an idea, but don't rely on them. – Ben Miller Oct 21 '17 at 22:59
  • The estate should seek a refund of whatever the lawyer charged. – Andrew Lazarus Mar 28 at 23:04
  • When I first saw this question, I thought that the OP should get the lawyers advice in writing, follow it to the letter, and then when the big tax bill comes send it to the lawyer. And if the lawyer doesn't pay it, report her to the Bar Association. – JoeTaxpayer Mar 29 at 13:15
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There are two different possible taxes based on various scenarios proposed by the OP or the lawyer who drew up the OP's father's will or the OP's mother.

First, there is the estate tax which is paid by the estate of the deceased, and the heirs get what is left. Most estates in the US pay no estate tax whatsoever because most estates are smaller than $5.4M lifetime gift and estate tax exemption. But, for the record, even though IRAs pass from owner to beneficiary independent of whatever the will might say about the disposition of the IRAs, the value of the deceased's IRAs is part of the estate, and if the estate is large enough that estate tax is due and there is not enough money in the rest of the estate to pay the estate tax (e.g. most of the estate value is IRA money and there are no other investments, just a bank account with a small balance), then the executor of the will can petition the probate court to claw back some of the IRA money from the IRA beneficiaries to pay the estate tax due.

Second, there is income tax that the estate must pay on income received from the estate's assets, e.g. mutual fund dividends paid between the date of death and the distribution of the assets to the beneficiaries, or income from cashing in IRAs that have the estate as the beneficiary.

Now, most of OP's father's estate is in IRAs which have the OP's mother as the primary beneficiary and there are no named secondary beneficiaries. Thus, by default, the estate is the IRA beneficiary should the OP's mother disclaim the IRAs as the lawyer has suggested. As @JoeTaxpayer says in a comment, if the OP's mother disclaims the IRA, then the estate must distribute all the IRA assets to the three beneficiaries by December 31 of the year in which the fifth anniversary of the death occurs. If the estate decides to do this by itself, then the distribution from the IRA to the estate is taxable income to the estate (best avoided if possible because of the high tax rates on trusts). What is commonly done is that before December 31 of the year following the year in which the death occurred, the estate (as the beneficiary) informs the IRA Custodian that the estate's beneficiaries are the surviving spouse (50%), and the two children (25% each) and requests the IRA custodian to divide the IRA assets accordingly and let each beneficiary be responsible for meeting the requirements of the 5-year rule for his/her share. Any assets not distributed in timely fashion are subject to a 50% excise tax as penalty each year until such time as these monies are actually withdrawn explicitly from the IRA (that is, the excise tax is not deducted from the remaining IRA assets; the beneficiary has to pay the excise tax out of pocket). As far as the IRS is concerned, there are no yearly distribution requirements to be met but the IRA Custodial Agreement might have its own rules, and so Publication 590b recommends discussing the distribution requirements for the 5-year rule with the IRA Custodian. The money distributed from the IRA is taxable income to the recipients. In particular, the children cannot roll the money over into another IRA so as to avoid immediate taxation; the spouse might be able to roll over the money into another IRA, but I am not sure about this; Publication 590b is very confusing on this point. All this is assuming that the deceased passed away before well before his 70.5th birthday so that there are no issues with RMDs (the interactions of all the rules in this case is an even bigger can of worms that I will leave to someone else to explicate).

On the other hand, if the OP's mother does not disclaim the IRAs, then she, as the surviving spouse, has the option of treating the inherited IRAs as her own IRAs, and she could then name her two children as the beneficiaries of the inherited IRAs when she passes away. Of course, by the same token, she could opt to make someone else the beneficiary (e.g, her children from a previous marriage) or change her mind at any later time and make someone else the beneficiary (e.g. if she remarries, or becomes very fond of the person taking care of her in a nursing home and decides to leave all her assets to this person instead of her children, etc). But even if such disinheritances are unlikely and the children are perfectly happy to wait to inherit till Mom passes away, as JoeTaxpayer points out, by not disclaiming the IRAs, the OP's mother can delay taking distributions from the IRAs till age 70.5, etc. which is also a good option to have.

The worst scenario is for the OP's mother to not disclaim the IRAs, cash them in right away (huge income tax whack on her) or at least 50% of them, and gift the OP and his sibling half of what she withdrew (or possibly after taking into account what she had to pay in income tax on the distribution). Gift tax need not be paid by the OP's mother if she files Form 709 and reduces her lifetime combined gift and estate tax exemption, and the OP and his sibling don't owe any tax (income or otherwise) on the gift amount. But, all that money has changed from tax-deferred assets to ordinary assets, and any additional earnings on these assets in the future will be taxable income. So, unless the OP and his sibling need the cash right away (pay off credit card debt, make a downpayment on a house, etc), this is not a good idea at all.

3

She is very wrong.

If the IRA is a traditional, i.e. A pretax IRA (not a Roth), all withdrawals are subject to tax at one's marginal rate. Read that to mean that a large sum can easily push her into higher brackets than normal. If it stayed with her, she'd take smaller withdrawals and be able to throttle her tax impact.

Once she takes it all out, and gifts it to you, no gift tax is due, but there's form 709, where it's declared, and counts against her $5.5M lifetime estate exemption.

There are a few things in the world of finance that offend me as much as lawyer malpractice, going into an area they are ignorant of.

  • Thank you for your response. If she takes out enough to gift to us, do we not have to report it as income? Also, do you know how it would be taxed if she disclaims it and allows it to go to the estate where it would be distributed to the three of us according to the will? – FDRobinette Oct 21 '17 at 16:07
  • Mom disclaiming the IRA is not sufficient to ensure that the IRA beneficiary is the estate since it is possible (likely?) that the children are secondary beneficiaries (in equal shares); they would need to disclaim it too. The bad news is that someone has to pay income tax on the money taken out of a Traditional IRA, whether it is the estate or Mom or the children and for Mom to take out 50% of the IRA money and give equal shares as gifts to the children is the worst possible advice. – Dilip Sarwate Oct 21 '17 at 16:23
  • @DilipSarwate Would you mind on elaborating on that last sentence? If what JoeTaxpayer said is true (the gifts would not be taxed), why would that be the worst scenario? Also, just as a note, there are no secondary beneficiaries assigned to the IRAs. – FDRobinette Oct 21 '17 at 16:26
  • No. If she withdraws, she pays the income tax, at her rate, and as long as files the Form 709, avoids paying the gift tax. You and your sister would not have to pay any tax. Mom disclaiming the beneficiary form may have an adverse effect on her own inheritance. Inheriting via will might force a 5 year payout (and taxes). Inheriting via beneficiary form leaves her to move funds into her own account and take RMDs post 70 if she wishes. – JoeTaxpayer Oct 21 '17 at 16:38
  • @FDRobinette See my own separate answer. – Dilip Sarwate Oct 22 '17 at 4:02

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