Leaving an IRA to your grandchildren can be an excellent, tax-advantaged way to contribute to their financial future.
However, if your grandchildren are minors, you'll have to make some choices about setting up a financial custodian or a trust to manage the money until they reach adulthood.
RMDs and taxes also play a part, so best to get the facts ahead of time and make sure all involved know what to expect.
I'm 72 and thinking about leaving one of my IRAs to my grandchildren, ages 19, 13, 9 and 8. Can you tell me if this is a good idea especially since they are minors and what their RMD requirements would be?—A Reader
In many ways, leaving an IRA to your grandchildren can be a great idea. The money continues to grow tax-deferred during your lifetime, and when your grandkids do inherit it, they'll be able to withdraw the money slowly over the course of their lifetimes, among other options.
However, it's not quite as simple as just naming them as the beneficiaries, for a few reasons. First, as you mention, required minimum distribution (RMD) rules can be complicated, especially when there is more than one beneficiary. In addition, you need to think about what would happen should your grandchildren inherit the money while they're still minors. And third, you’ll want to think about how the distributions will be taxed. So while I applaud your generosity and forethought—and in no way want to dissuade you—here are some things to address in advance.
Minors can't inherit an IRA outright
The age of majority generally ranges from 18 to 21, depending on the state of residence. So in your case, while your oldest grandchild might be able to inherit money directly, you should strongly consider establishing a custodian, typically the minor’s legal guardian, for the three younger ones. The custodian would manage the money until the child reached his or her state’s recognized age of adulthood. At that time, the child would have complete access to the funds. If you don't designate a custodian, the child’s parent would have to ask the Probate Court to assign a property guardian. To avoid this complication, it would be best to name a custodian (often a parent) as part of your beneficiary designation.
Another option is to set up a trust. This requires a bit more expense and time (you will need to work with an estate planning attorney), but it will give you more control over how and when the money can be used. For instance, while you might be thinking the inheritance would be used for education or a down payment on a house, a young beneficiary might be more tempted to buy a fancy car. To me, the choice of a trust depends on how much money you're talking about and how concerned you are about your grandchildren handling their inheritance responsibly.
All heirs have to take an RMD—even from a Roth IRA
As you mention, required minimum distributions (RMDs) also come into play. Because you're past age 70½, your heirs would have to take an RMD starting the first year after your death (unless they take the money as a lump sum). This applies to both traditional and Roth IRAs. The annual RMD is based on life expectancy; so for a grandchild, that amount would generally be much lower than for an older person. The RMD will go up every year as he or she ages and the account potentially grows.
But here's one catch. When an IRA is passed on, it's important that what is called an Inherited IRA be opened in the name of the original account holder for the benefit of the beneficiary; that way the beneficiary doesn’t have to pay income taxes on the amount inherited until it is withdrawn and the money can continue to grow tax deferred. When there are multiple beneficiaries as in your case, a separate Inherited IRA should be opened in the name of each beneficiary after your death. Otherwise RMDs will be based on the life expectancy of the oldest beneficiary. I'd make sure the custodian you designate is aware of this.
Unless your IRA is a Roth, the kids will most likely have to pay income taxes on distributions
Distributions from earnings and deductible contributions from a traditional IRA are considered ordinary income, so unless you're passing on a Roth IRA that was established for at least 5 years or more prior to your passing, taxes will be due on distributions. If the Roth five-year holding period has not passed, the earnings are taxed at ordinary income rates. Your grandchildren will have to pay income taxes on distributions at their own tax rate.
Two practical considerations
Just for the record, its best that your grandchildren (or their custodians) understand that they will not be able to make additional contributions to an inherited IRA (however, if they have earned income, their parents can set up custodial IRAs for them).
And on a positive note, it is also important for everyone to understand that your grandchildren would not be subject to the 10% early withdrawal penalty, regardless of their age when they take a distribution.
Run this by an advisor
Naming a grandchild as an IRA beneficiary can be an excellent, tax-smart way to pass on money—both for you and for your grandkids. But as you can see, the devil is in the details, so I strongly suggest talking this over with your financial advisor and estate planning attorney. You just want to make sure that you set it up to everyone's best advantage now, so it can truly be an advantage to the kids later on.
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