Thanks Mom! Now What Do I Do?

Earlier in the week, I got an interesting call from a nice young woman from Mashpee who wanted to make an appointment to see me. Kathleen is 45 and her mother passed away last year after a lengthy illness. Kathleen told me that her Mom left her and her brother, Teddy, who is age 55, two IRAs. (Pay attention to their ages; it will become important.) She told me that her current financial advisor is recommending that they combine the two IRAs into one for ease of management because less paperwork would be required. Kathleen was not confident that this was sound advice and wanted to speak to someone who specializes in retirement vehicles, such as IRA’s, and inheritance rules. Her research led her to me. Let’s take a look.
Kathleen came to see me on Thursday at our new Falmouth office where we discussed the two IRAs that her mother left to her and Teddy. The first IRA was pretty straight-forward. Her Mom properly filled out the IRA beneficiary form and listed both Kathleen and Teddy as a 50/50 split.
The challenge came with the beneficiary selection of the second IRA. Somewhere along the line, Kathleen’s Mom set up a trust for the benefit of her children and named the trust as the beneficiary of the second IRA. Kathleen and Teddy were each listed as a 50% beneficiary of the trust, not the IRA.
This is where it gets tricky so stay with me. Pursuant to the terms of the trust Kathleen’s mom created, the trust was to acquire the IRA assets and then terminate by distributing those assets to the trust beneficiaries. In other words, in this case we must look to the trust language not the beneficiary form like we did for the first IRA. I know Kathleen and Teddy’s Mom had the best intentions, however, in my opinion, this is generally the WORST type of trust to name as an IRA beneficiary. Let me explain why.
I reached out to Geoff Nickerson, an attorney at the Falmouth law firm of Oppenheim & Nickerson LLP. Geoff notes that while trusts are an effective estate planning tools, they must be used carefully. “Trusts are not one-size-fits-all instruments. When it comes to estate and wealth planning, the first step is to assemble the right team. The second step is to keep the conversation going not only between you and your advisors, but also between and among your advisors to avoid unintended results.” Great advice Geoff!
Generally, beneficiaries of IRAs must take required minimum distributions (RMD’s). An RMD is a calculation based upon the recipient’s life expectancy. The longer the life expectancy of a beneficiary, the smaller the required minimum distribution can be, which is beneficial for a number of reasons. So, with respect to the first IRA for which Kathleen’s Mom properly listed her children as the beneficiaries, Kathleen and Teddy will each be permitted to take RMDs based upon their respective ages. This helps Kathleen to stretch her IRA distributions for more years than Teddy will be permitted to because she is younger than him, which allows Kathleen the benefit of more deferred growth by taking a smaller RMD based on her younger age and longer life expectancy.
However, because the trust is the beneficiary of the second IRA, trust rules are used for calculating required RMDs from that IRA. Trust rules provide that the life expectancy of the oldest trust beneficiary is used in this case for purposes of calculating the RMDs. This is a shame, since now Kathleen cannot use her own life expectancy to calculate her RMD. Rather, in this case both Kathleen and Teddy must use the life expectancy of the oldest trust beneficiary, Teddy. Kathleen gets the short end of the stick here because she must use Teddy’s life expectancy to calculate her RMDs, even though the assets of the IRA will be distributed out of the trust when the trust is terminated.
Based upon the trust language, I advised Kathleen to split her Mom’s two IRAs into four IRAs. That way Kathleen and Teddy will each have one IRA inherited directly and one inherited through the trust. Although under normal circumstances, a beneficiary can combine IRAs inherited from the same individual, Kathleen is not dealing with normal circumstances because she is not inheriting the second IRA. As explained previously, she is the beneficiary of a trust that is acquiring the assets of the second IRA. In her case, between the two IRAs, there are actually three beneficiaries, Kathleen, Teddy, and the Trust. Kathleen will end up with two IRAs inherited from her mother. She must use two different ages for calculating her required minimum distributions. For the first IRA that she inherited as a direct beneficiary, Kathleen can use her age of 45 to calculate her required minimum distribution (RMD). However, as previously explained, Kathleen will need to use Teddy’s age of 55 for calculating her RMD from the second IRA that she inherited through the trust, thereby increasing the amount of her distribution and possibly pushing her into a higher tax bracket. I pointed out that while her current financial advisor recommended to combine her two inherited IRA’s into one, Kathleen should not combine those two IRA accounts since the RMD’s are calculated from two different ages.
Cutter Family Finance readers, you are well informed. Please remember that when a trust is named as the beneficiary of an IRA, the trust is the beneficiary. The IRA funds are the property of the trust, not the trust beneficiaries and therefore trust distribution rules apply. In this case, the age of the oldest trust beneficiary is used to calculate the required minimum distribution.
If you are considering using a trust as the beneficiary of an IRA, you need to find an attorney and a financial advisor who not only can create a trust, but who also know both the IRA and trust distribution rules. Those folks are not easy to find, but don’t settle for anything less because You Deserve More!