Pass an IRA to Young Grandkids With Care

Leaving an IRA to your grandchildren can be one of the greatest gifts a grandparent can give. A young person who inherits a traditional or Roth IRA has to take only minimal distributions each year over a lifetime, enabling the tax-sheltered account to grow for decades.

But you should take some precautions to protect your legacy. A minor child cannot inherit an IRA outright. You have two basic options if you're leaving an IRA to a minor. One route is to designate the grandchild as a beneficiary of your IRA and appoint a custodian who will oversee the account if you die before the child reaches adulthood. The other choice is to leave the IRA to a trust, which would allow you to dictate how your heirs use the money after you die.

If you choose to designate your young grandchild as the beneficiary, you can name your adult child or another trusted person as the custodian. You can also name a back-up in case the first custodian is unable to serve. A custodian is authorized to manage the account, including taking distributions and making trades.

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If you die without naming a custodian, or the designated custodians cannot serve, the matter can end up in court. A parent or someone else seeking guardianship over the IRA will have to ask the court to be appointed as custodian.

Ask the bank or brokerage firm that holds your IRA about its requirements for naming young grandchildren as beneficiaries. Some firms will not open IRAs for minors and won't allow minors to be named as beneficiaries, says Denise Appleby, of Appleby Retirement Consulting, in Grayson, Ga. If you run into that roadblock, you can transfer your IRA to a firm that allows minors to hold IRAs. Charles Schwab, T. Rowe Price, Vanguard and Wells Fargo are among the firms that allow minors to hold IRAs.

The downside: The grandchildren will get their hands on the money when they turn 18 or 21, depending on the state where they live. You may have intended that your grandchild stretch withdrawals over his lifetime, but perhaps he'd prefer to buy a Ferrari. "Once they reach the age of majority, the custodian is removed from the equation," says Appleby.

That's where a trust comes in. If you worry that the young beneficiary will misuse the account, you can arrange for the trust to become the IRA beneficiary and for the minor to become a beneficiary of the trust. "If the intention is really to have more control over the assets after the age of majority, you may want to consider naming a trust as beneficiary," says Michele Grant, director of IRAs for Wells Fargo.A trust offers a lot of flexibility. You can dictate how fast the money can be spent or what it can be spent on. You can set up the trust to force an heir to take distributions over his life expectancy, or the trust could dole out a set amount—say, $20,000 a year—to the beneficiary. "A trust is like your own little rulebook," says Jeffrey Levine, IRA technical consultant for Ed Slott and Co., which provides IRA advice.

Kiplinger's Retirement Report subscriber, Dick Vink, 72, and his wife, Kitty, 67, of Costa Mesa, Cal., intend to leave IRA money to their ten grandchildren. They are wrestling with whether to use a trust, in case the two of them die while their grandkids are still minors. "We would like them to use the money for college," he says. And the couple would like to restrict access to any money not used for college, Vink says.

A trust can provide the kind of control the Vinks want, but trusts can be complicated. You will need to see an estate-planning lawyer to make sure the trust meets IRS rules for IRAs. It can cost several thousand dollars to set up the trust. For smaller balances, a trust may not be worth the trouble.

While a trust provides control, it doesn't provide any tax benefits. And it could cause some heirs to pay more in tax. Beneficiaries who receive payouts straight from a trust will be taxed at their individual income rate. But if there is a delay in payouts—perhaps you don't want your grandchild to start receiving money until she's 30—required minimum distributions and earnings on the RMDs that accumulate in the trust in the interim will be taxed annually at the rates that apply to trusts. Income tax brackets for trusts are much lower than for personal income—for 2014, the highest tax rate of 39.6% kicks in on trust income exceeding $12,150. That means more income will be hit by taxes and at higher rates. You could avoid this issue by converting your IRA to a Roth IRA; you'll pay income tax on the conversion, but distributions from the trust will be tax free.

The Power of Youth

Whichever way you pass on your retirement account assets, leaving an IRA can provide a grandchild with a significant financial foundation. Heirs of both traditional and Roth IRAs must take required minimum distributions over their own life expectancies if they want to "stretch" the tax shelter. For young heirs, the account could grow for decades. The first RMD must be taken the year after the original owner died. The distributions will be taxable if they come out of a traditional IRA and tax free if they come out of a Roth.

Because of longer life expectancy, a younger heir can withdraw less money than an older one. The first RMD for a ten-year-old who inherits a $200,000 IRA that grows 6% a year would be about $2,950. If instead a 20-year-old inherits that IRA, she would have a first RMD of about $3,400. You can test out beneficiary RMD scenarios with an online calculator at www.schwab.com/benermdcalc.

The amount a young heir must withdraw will increase each year as she ages and the account grows. As with your own RMDs, the distribution calculation factors in both age and account balance. Based on the 6% growth rate, the second distribution of the ten-year-old above would rise to about $3,130. By the time that heir turns 68, the account would be worth about $1.3 million—and the RMD would be about $89,560.

If you have ever stashed nondeductible contributions into the IRA, keep copies of Form 8606, which tracks those contributions. That money isn't taxable when it comes out of the IRA, but heirs will need the paperwork to prove that. "People end up paying tax when they don't need to," Appleby says.

Another bonus of a young grandchild inheriting a traditional IRA: A portion of the distributions will be taxed at the tax rate of the child, which is likely to be lower than the grandparent’s tax rate or the parent’s tax rate. RMDs are subject to the kiddie “tax”; that means in 2017 a young child’s unearned income over $2,100 is taxed at the parent’s rate. After the child turns 18 (or age 24, if a full-time student), the full inherited IRA RMD will be taxed at the child’s rate.