Look Out for the Kiddie Tax When Leaving an IRA to a Minor

Leaving your IRA to your children or grandchildren can seem like an obvious choice—you can leave a sizable asset to someone in a lower tax bracket while your tax-sheltered account grows for 10 years or more. However, young children may be subject to the kiddie tax. Being aware of the potential drawbacks can help you draft your estate plan in a way that maximizes your gifts to your beneficiaries.

How an IRA Works

An Individual Retirement Account (IRA) is a financial account that provides a tax shelter for retirement funds. IRAs are opened at a bank or other financial institution and are funded by investments such as stocks, mutual funds, or bonds.

Traditional IRAs. The money placed in a traditional IRA is deducted from your taxable income, which reduces your tax liability for that year. For example, if you place $6,500 a year into your IRA every year until you retire, the fund grows tax-free. You are not taxed on these funds until you withdraw them at retirement. This option provides you with tax-deferred growth.

Roth IRAs. In contrast, a Roth IRA is funded with post-tax income. You don't get any immediate tax deduction for your contribution. However, you can make withdrawals from your contributions at any time, and withdrawals from your earnings as well as contributions after age 59½, without incurring any additional taxes. This option is preferred by people who think the tax rate will be higher when they retire. They pay the tax now and take tax-free withdrawals during their retirement.

Traditional and Roth IRAs can currently be funded with up to $6,500 a year (in 2023) until a person reaches age 50, at which point he or she can contribute $7,500 a year. If a person contributed $6,500 for 30 years and then $7,500 for ten years, the principal of the account would equal $270,000, along with any earnings on it. Investors must take care in determining how to pass on a valuable asset like this and understanding the tax implications.

IRA Beneficiaries

An account owner can name a name a spouse, another person who's not a spouse, or a charity as the beneficiary of the IRA. Sometimes when an account owner's adult child is financially secure, the account owner might skip over the adult child and name a grandchild as a beneficiary.

When an IRA owner dies, the value of the IRA is transferred to the named beneficiary. This designation overrides any contradictory information in a will. (But failing to name a beneficiary on the beneficiary designation form provided by your IRA provider might result in your retirement money going through probate—costing your heirs time and money—so use the form!)

Required Minimum Distributions (RMDs)

Under the rules of the SECURE Act, starting in 2020, most non-spouse beneficiaries are required to withdraw the entirety of the inherited IRA with ten years of the account holder's death. There are a few exceptions; for example, children who are still minors can make withdrawals based on their young age. The required amount of withdrawal, or RMD, is based on the child's life expectancy as established by IRS actuarial tables—because the child is young, the amount of the RMD will likely be relatively small. However, once they are no longer minors (usually upon reaching age 18), they will then have ten years in which to deplete the retirement account.

Spouses can roll the IRA into their own name and are not required to take RMDs at the time of they take ownership of the account unless they have reached the mandatory distribution age—which used to be 72 for traditional IRAs, but beginning in 2023 (with the SECURE 2.0 Act) is 73. (Roth IRAs do not have a mandatory distribution age.)

What Is the Kiddie Tax?

Typically, a child's tax rate is much lower than a parent's tax rate due to having much less income. However, certain types of income, including inherited traditional IRAs, are subject to the kiddie tax, are taxed at the parent's highest tax rate after a certain threshold amount ($2,500 in 2023). This applies to children who are under 18, or, if the child is a full-time student, children under 24.

Tax Effects of RMDs for Child Beneficiaries

IRA account owners who are considering leaving a tax-deferred IRA (such as a traditional IRA) to a child should be aware that RMDs are taxed and, in the case of children under age 18 (or full-time students under age 24), are taxed at a parent's usually higher rate.

Example: Becky, who is 20 years old and a full-time college student, inherits her grandfather's IRA. Becky's parents' highest tax rate is 35%. Any withdrawals over $2,500 she makes from the IRA will be subject to that 35% tax rate. However, once Becky turns 24 (or is no longer in full-time school), the tax rate on her withdrawals will be at her own tax rate, which will likely be lower.

Roth IRAs are a bit different. Since the money used to fund Roth IRAs has already been taxed, distributions from inherited Roth IRAs are tax-free. However, the beneficiary will still have to deplete the account within ten years after becoming an adult.

Account owners who want to avoid the kiddie tax can talk to their financial advisor or estate planning attorney to see if converting a traditional IRA to a Roth IRA is recommended as a tax-saving option.

Managing Property Left to Child Beneficiaries Who Are Minors

Taxes are not the only problem to think about when leaving an IRA to a minor beneficiary. An adult must be appointed to oversee the account while the child is still a minor (the exact age that constitutes a minor depends on state law but is usually 18). The easiest way to do this is to name a trusted adult to serve as "custodian" of the money. Custodians are authorized under a law called the Uniform Transfers to Minors Act (UTMA), which has been adopted by all states.

If you don't appoint a custodian, and a child inherits more than a few thousand dollars, the child's parents will probably have to go to court and ask to be appointed guardians of the money. If neither parent is alive, the child's court-appointed and court-supervised guardian will handle the money. In either event, this process costs time and money.

Getting Help

To get further guidance in determining the best option for naming a minor as a beneficiary to your IRA account, talk to your financial advisor and an estate planning attorney.