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
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
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
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.
, 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
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
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: 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. If the child has no other taxable income for the
year and if the annual distribution is small enough, she may owe no
tax at all.