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Financial Advice

Don't Make the Client's Problem Your Problem

Contributor Natalie Choate with what not to do to 'help' clients.

What happens when a person dies without a proper estate plan? Often, unnecessary taxes, higher expenses, and other bad consequences ensue. When the decedent’s widow and children are sitting in the advisor’s office looking at these consequences, they are upset and sad and worried about their financial future. And the advisor feels their pain. The advisor would like to alleviate that pain. The advisor would like to be the savior who can fix everything and make those bad consequences go away.

If you are that advisor, and you can find the novel theory, the brilliant fix, or the clever workaround that will make the problem go away--wonderful! By all means, go ahead. But be wary of turning the client's problem into your problem. I occasionally hear of "planning ideas" that involve backdating documents, ignoring facts, bending rules, and/or other unacceptable moves to supposedly fix a problem. Using ideas like this will make the problem worse--and potentially land you in trouble along with your clients.

Example: The Forgetful Father Widowed father George never got around to naming a beneficiary for his IRA. If he had bothered to fill out the beneficiary designation form, he would have named his only child Tom as his designated beneficiary. Tom, age 45, is a mentally competent adult who has a severe disability. Instead, when George died at age 68, the account passed to his estate, which was the "default beneficiary" under the IRA agreement.

George's will left his entire estate to Tom, so Tom inherited the IRA through the estate. But because of the IRS' rule that an estate cannot be a "designated beneficiary," Tom is not entitled to the life expectancy payout allowed to designated beneficiaries who are "eligible designated beneficiaries." If Tom had been named directly as designated beneficiary, he would have been entitled to the life expectancy payout because (being disabled) he qualifies as an eligible designated beneficiary. Instead, required minimum distributions, or RMDs, from the IRA will be governed by the five-year rule--the entire account must be distributed no later than the end of the year that contains the fifth anniversary of George's death.

Tom opened an "inherited IRA" (in the name "Tom, as beneficiary of George"). The executor of George's estate caused the assets of George's IRA (titled "Estate as beneficiary of George”) to be transferred into the inherited IRA in Tom's name, and the estate was closed. So far, everything is legal.

But Tom and the advisor are not happy, because the five-year payout rule still applies, even though the IRA has been legally and properly transferred into an inherited IRA in Tom's name. Tom is losing out on the long-term income tax deferral that would have been available under the "life expectancy payout method" if George had only named Tom directly as designated beneficiary of the IRA. Since Tom is only 45 years old, that's a potential payout of about 40 years.

So, the advisor asks, now that the IRA has been transferred into an inherited IRA in Tom's name, why doesn't Tom just use the life expectancy payout and forget about the five-year rule? As the advisor put it, how will anyone ever know Tom originally inherited the IRA through the estate (the five-year rule applies) and not directly from George (the life expectancy payout applies)?

This advisor's planning idea is a classic example of turning the client's problem into the advisor's problem. Any plan that depends on the assumption that "no one will ever find out" is a bad plan--in this case a very bad plan.

Suppose Tom actually does take annual distributions based on the life expectancy payout that he is not (under current rules) entitled to use. Tom will knowingly be filing false income tax returns (because Tom is representing on each return that there are no penalties due on the inherited IRA, even though he knows that's not true) every year for the rest of his life expectancy, while running up 50% excise taxes, each year starting with the fifth year, on the amount that was supposed to be withdrawn but wasn't.

Reminder: Under the five-year rule, the minimum distribution is 100% of the account in the fifth year--and that continues to be the annual RMD every year from then until the account is exhausted. If the IRS finds out, it can assess the 50% excise tax for failure to withdraw the entire account year after year. The statute of limitations will not expire for all the missed RMD years until, at the earliest, three to six years after Tom empties the account.

The IRS routinely grants waivers of the 50% excise tax for "good cause," but deliberate tax evasion is presumably not "good cause."

How will the IRS find out that RMDs are not being computed correctly? Maybe a disgruntled ex-spouse or employee will inform them. Maybe someone who didn't quite get what the lie was supposed to be will just tell the IRS the truth by accident. Maybe the situation will just pop out in some other routine audit. Remember, this will be going on for 40 years, and that's a lot of potential audits.

And for good measure, the advisor may lose his or her professional license for knowingly advocating this conduct. Under what measure are these results better than just biting the bullet and paying the taxes owed on the inherited IRA?

Whenever a client or another advisor suggests a "fix" that doesn't seem right, take a step back and distance yourself from this problem that you didn't cause. Yes, unnecessarily high taxes are painful, and yes, as an advisor you hate to see people suffer these consequences of the decedent's negligence. But it was the decedent who made the mistake: He or she did not do proper planning, and when estate planning is neglected, the family will suffer. By all means search the universe for a creative and legal way to fix the mess--but in the end it was the decedent's mistake that caused this problem for his survivors. Don't jump into the mess with them.

Natalie Choate is an estate planning lawyer in Boston with Nutter McClennen & Fish LLP. Her practice is limited to consulting regarding retirement benefits. The new 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is now available through her website,, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article may or may not reflect the views of Morningstar.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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