Giving up an inheritance might sound like the act of a madman. After all, it's free money that's yours to keep. However when you inherit an individual retirement account, you might have good reasons to turn it down. Accepting the inherited IRA might mean taking mandatory distributions every year. These will boost your income -- and your tax liability.
Disclaiming an IRA
You have to disclaim an IRA within nine months of the account owner's death. Get in touch with the IRA trustee, typically a bank or other financial institution. Banks typically require that you complete a form and produce the death certificate. The IRS requires that you write a letter stating that you irrevocably disclaim the IRA. Submit the letter, along with the form and death certificate, if required, to the IRA trustee.
Taking assets from the IRA you plan to disclaim will void the disclaimer. You can, however, take the required minimum distribution for the year of death, because it must be distributed by Dec. 31 of each year. The RMD amount is based on life expectancy as determined by IRS tables. The younger the beneficiary, the smaller the amount of the yearly RMD. The smaller the RMD figure, the lower the yearly tax liability.
Spouse Beneficiary
If your spouse leaves you an IRA, you have a convenient option. You can treat it as your own IRA -- assume the IRA -- and start making contributions to it. You won't need to start taking distributions until you turn 70 1/2. This option does not immediately increase your tax liability and allows the account to continue to grow, tax-deferred.
Non-Spouse Beneficiary
On the other hand, if you inherit an IRA and are not the spouse of the decedent, you have two choices. You can take the entire amount of the IRA as a lump sum within five years or start taking the RMDs right away. Spouses can also choose one of these options. A non-spouse beneficiary might want to disclaim an IRA in favor of a contingent beneficiary to reduce taxes and allow the IRA to remain open -- accruing earnings -- for as long as possible.
Primary vs. Contingent Beneficiary
The primary beneficiary of an IRA is the decedent's first choice to inherit the account. The contingent beneficiary is the next in line. For example, the decedent might have designated a child as primary beneficiary and a grandchild as contingent. If you, as primary beneficiary, disclaim an IRA to which there is no contingent beneficiary, the proceeds of the account will go to the decedent's estate. Estate taxes can be considerable.
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