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 decades. However, young grandchildren are required to take taxable, minimal distributions and 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.
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.
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 $5,000 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.
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 without incurring any additional taxes or penalties. 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 $5,500 a year until a person reaches age 50, at which point he or she can contribute $6,500 a year. If a person contributed $5,500 for 30 years and then $6,500 for ten years, the principal of the account would equal $230,000, along with any earnings on it. Investors must take care in determining how to pass on a valuable asset like this and its tax implications.
An account owner can name a spouse, another person not a spouse, or a charity as the beneficiary of the IRA. Sometimes when an account owner’s adult child is financially secure, he or she might skip over this person and name the grandchild as a beneficiary.
When an IRA owner dies, the value of the IRA is transferred to the named beneficiary. This designation supersedes any contradictory information in a will unless there is no beneficiary or the named beneficiary is your estate.
Non-spouse beneficiaries are required to take Required Minimum Distributions (RMDs) even if they are minors. This means that the child must make certain withdrawals from the account over the course of his or her lifetime. These distributions must begin the year after the beneficiary died. These withdrawals are considered unearned income on which tax must be paid. The amount of RMDs is based on the amount of the account divided by the beneficiary’s life expectancy rate (established by the IRS).
Spouses can roll the IRA into their own name and are not required to take RMDs at the time of taking over ownership of the account until they reach the mandatory distribution age.
Typically, a child’s tax rate is much lower than his or her parents’ tax rate due to having much less income. For many children, an asset incurs no tax because of the low tax rate and standard deduction. However, certain types of wealth transfers are subject to the kiddie tax, which taxes the child at a higher rate. After the child turns 18 (or age 24 if the child is a full-time student), the earnings and income are taxed at the child’s rate, which would typically be lower than the account owner’s tax rate.
IRA account owners who are considering leaving a tax-deferred IRA should be aware of tax rules that apply to RMDs. These distributions are taxed. Previously, the kiddie tax rate would be applied to any interest, dividends, or capital gains above $2,100. The child’s tax rate was based at the same tax rate as their parents. In the example above, the child’s parents may have been wealthy and had a 35% tax rate. If the required withdrawal is $7,000, the child would be required to apply the 35%-tax rate to $4,900 ($7,000 - $2,100), for a total tax of $1,715.
Beginning in 2018 and lasting until 2025, the kiddie tax rates were adjusted to mirror trust account rates. Now, any unearned income up to $2,600 is not taxed. From $2,601 to $12,700 in unearned income, a 15% tax rate applies. Any income or dividends higher than $12,700 are subject to a 20% tax rate. Using the same example above, $4,900 would be subject to the 15% tax rate, or $735. The amount of required minimum distributions may increase over time since this amount is based on the age of the beneficiary and the account balance.
Minors who inherit Roth IRA accounts must also take RMDs. However, since the money used to fund this account has already been taxed, these distributions are tax-free. Account owners who want to avoid the kiddie tax can talk to their financial advisor or estate planning attorney to see if converting the IRA to a Roth IRA is recommended for a tax-saving option.
Tax isn’t the only problem to think about when leaving an IRA to a minor beneficiary. Children aren’t legally allowed to own property outright. A custodian may be appointed to oversee the account while the child is a minor. But, a child can inherit the account outright when they turn 18 or 21, depending on state law. The child can then cash out the account and potentially face penalties and negative tax effects. Account owners who want to ensure the IRA will provide payouts to the child over the child’s lifetime can instead name a trust as the beneficiary of the account. The tax laws until 2025 assign the trust rate for the kiddie tax rate, so there’s no difference in the tax structure of this approach. Yet, a trust provides greater structure so that you can determine how the trust funds and RMDs are used. For example, the account owner might restrict distributions so that much of the fund is used to pay for college tuition and related expenses. Or, the account owner can have the RMDs deposited back into the trust and pay for lump-sum payments at certain ages, like 30 or 40.
You can name the child’s parent or other trusted person as the trustee, or you can name a bank or financial institution to fulfill this role.
To determine the best option available for naming a minor as a beneficiary to an IRA account, talk to your financial advisor and an estate planning attorney.