Karen, and Bob, both age 78, are in a second marriage, and each has children from a prior marriage. A sizeable portion of their net worth is Karen’s Traditional IRA account worth approximately $3.5 million. Karen takes her Required Minimum Distributions (RMDs) each year. The divisor under the Uniform Life Table that governs Karen’s IRA this year is 20.3, resulting in a RMD of approximately $172,400.

Currently, Bob is the primary beneficiary of Karen’s IRA. Karen’s children are the contingent beneficiaries.

They arrive at my office with a dilemma. “What I’d like to do,” Karen says, “is if Bob survives me, I want my IRA to go into a trust for him, but whatever he doesn’t use would go back to my children.”

Because Bob is currently the primary beneficiary, Bob could, if he survives Karen, roll over her IRA. He would then take RMDs based upon the same Uniform Life Table that Karen now takes. When Bob rolls over the IRA, he could name whomever he wants as his primary beneficiary, which worries Karen.

It’s not that Karen doesn’t trust Bob, “It’s just that he could become vulnerable later in life due to dementia, or what if my children somehow upset him and he decides to change the beneficiaries,” she noted. Bob wasn’t offended and nodded in agreement.

“That’s not the only danger,” I pointed out. “If Bob were to remarry without a nuptial agreement, even if he left Karen’s children as the IRA primary beneficiaries, his new wife could take what’s known as a spousal elective share under the law. She might be entitled to as much as half of the IRA balance.”

“So that’s why I want to put the IRA in a trust for Bob if I go first,” Karen said.

“Well, there’s a problem with that strategy too,” I noted, pulling out the IRS RMD charts. “The only person who can roll over an IRA is a spouse. Provided the spouse does, in fact, roll over the IRA, then the Uniform Life Table applies. If the IRA isn’t rolled over, however, then the Single Life Table applies,” I continued, pulling out that chart.

The Single Life Table is used for non-spouse beneficiaries, or for spouses who don’t roll over the IRA. It is a much more aggressive RMD schedule.

“You’ll see that the Single Life Table the divisor for a 78 year old is 11.4 rather than the 20.3 that you find on the Uniform Life Table. So a $3.5 million IRA account would result in a RMD of approximately $307,000. Moreover, the Single Life Table’s annual divisor is not pursuant to the age of the beneficiary after the first RMD. Instead, you subtract one from the previous year’s divisor. In other words, the next year’s divisor would be 10.4, then 9.4 and so on. What this means is that the entire IRA account, all $3.5 million of it, will have been withdrawn within 10 years.”

Karen’s mouth gaped open. “You mean that if Bob lives ten years beyond me, the entire IRA is gone if we name a trust as his beneficiary?”

“Yes. But I’m not done with the bad news yet.” I said. “In order for the trust to qualify Bob as an ‘identifiable beneficiary’ under IRS rules, there are five requirements, one of which is that the trust act as a ‘conduit’. What that means is the income that is distributed from the IRA to the trust goes right through the trust to Bob. In other words, there’s nothing preserved for Karen’s children. Bob has control over all the distributions, even if he doesn’t need the entire amount for his living expenses. We could draft provisions that would toggle the trust to an accumulation trust, but when you do that the trust ends up paying the highest marginal tax rate once $12,750 is accumulated. That’s a bad result too.”

I added that when a trust is the beneficiary to an IRA, the identifiable beneficiary rules were important to satisfy, otherwise the entire income not yet taxed all becomes taxable in the year following the IRA account owner’s death. This is a terrible result because so much of the IRA is lost to income taxes right away, and all of the tax deferred growth is lost as well.

As an aside, in my thirty years of practicing law, I’ve seen many mistakes when clients name trusts as the beneficiaries to an IRA, often because their financial or legal advisor failed to understand the distribution rules that I explained to Karen and Bob.

There are answers to Bob and Karen’s dilemma, although not enough space in today’s column for me to review them all. For more information please visit http://estateprograms.com/explore/tax-efficient/#IRA.

© 2019 Craig R. Hersch. Originally published in the Sanibel Island Sun.