I ran across a sad story this morning that can illustrate several points, both financial and behavioral. It's a story of parents who left behind money and children who made one wrong move.
A father past away and left a large IRA to his wife. The wife rolled his IRA into her IRA. This is a normal and natural thing to do. No tax consequences as the tax code allows for this to happen every day. Eventually, the mother died. Rather than leaving the money directly to the kids as primary beneficiaries, she made a trust the beneficiary of the IRA.
One of the keys to the story is that the kids were both trustees of the trust and the beneficiaries of the trust. So that means they really had full control of the IRA funds. It was 2020 at the time and the kids decided they didn't like the investment choices at the custodian. They could only do mutual funds and they wanted to pick stocks themselves. The custodian regretfully informed them that they could only access mutual funds so they decided to switch custodians.
So they setup a trust brokerage account at the new custodian firm and transferred the funds from one custodian to another. Do you see the problem yet? They set up a trust at the new custodian. Not an IRA. This means they distributed all the money from the IRA to a non-qualified trust brokerage account. This means that all those millions of dollars count as ordinary income.
When tax time came, they realized their mistake. They asked for an exception from the IRS so they could reverse the distribution. How do you think that worked out. You can find out here: click here. Suffice it say, it didn’t go their way.
A few morals of the story:
- Kudos to mom for trying to protect her children from themselves. But did she? If the kids were both the trustees and the beneficiaries, then there’s no spendthrift protection to speak of.
- What transferred from Dad and Mom to the kids was money. However, what did not transfer was an understanding of the rules about money. Most likely Mom and Dad didn’t inherit vast wealth and didn't realize how one signature on a one piece of paper could cost so much to their heirs. There is no full proof estate plan without educating your heirs as to what and how they are getting their inheritance.
- Where was the advisor(s)? Both custodians should have stopped this transaction at several steps in the process. Keep in mind, it's not their responsibility they are simply passive, disinterested parties who help you with your transactions for a nominal fee. Did the kids think they were getting advice? Did they not have a CPA? Did they not have a financial advisor?
- Your financial team should be lead by your CPA and financial advisor. They don't provide value by guessing which stock will go up the most in the next three years. They provide value by helping you not do stupid things. Like taking a 100% distribution on an inherited IRA. Like spending your money frivolously on wine, women and song. Like not taking vacations when you can clearly afford to do so. Like stopping you from investing in some hair-brained scheme your proctologist told you about a the club house. That's the value of a multitude of counselors.
If you'd like to hear me rant some more, book a call.