When you ask most people who they want to leave their assets to at their death, the overwhelming answer is: their children. However, leaving your IRA to your grandchildren instead of your children can result in significantly greater asset growth and tax savings.
Most people have one or more traditional IRAs. Often, these started out as 401Ks where the owner contributed pre-tax funds from his or her paycheck, and after retirement rolled the 401K into an IRA. For a traditional IRA, once the owner turns age 70 ½, he or she must begin to take required minimum distributions (“RMDs”) based on his or her life expectancy, and these distributions are subject to income tax. This makes sense – the IRS wants their tax dollars at some point. Roth IRAs are another retirement savings vehicle. Roth IRAs contain after-tax funds. Because these funds have already been taxed, the owners are not forced to take withdrawals during their lifetimes.
When you name a non-spouse individual as the beneficiary of your traditional or Roth IRA, at your death that individual has the option of transferring the assets into an inherited IRA and taking distributions out over his or her life expectancy. RMDs must start the year after the IRA owner’s death. The distributions will be taxable if they come out of a traditional IRA and tax free if they come out of a Roth. In either case, the benefit of keeping the IRA intact can be huge. As long as funds remain in the IRA, they continue to grow income tax deferred in the case of a traditional IRA and income tax free in the case of a Roth IRA.
Imagine you die with $200,000 in a traditional IRA. If your beneficiary withdraws all the funds immediately, he or she will have to pay income tax on that amount. However, if the beneficiary keeps the funds in the IRA, the beneficiary just has to withdraw small amounts each year based on his or her life expectancy. This means that the bulk of that $200,000 is going to continue to grow without being reduced by income taxes. Because of a longer life expectancy, a grandchild can withdraw less money than a child, which compounds these benefits.
To illustrate using the same example as above, an eleven-year-old grandchild would be able to withdraw $2,785.52 in the first year and continue to withdraw gradually larger amounts for the remainder of the grandchild’s life expectancy. Assuming an annual growth rate of 6%, when the grandchild turns 50, the IRA would then hold $954,536 with that year’s RMD at $28,267; when the grandchild turns 65, the IRA would then hold $1,253,945 with the RMD at $70,178. Another bonus of a young grandchild inheriting a traditional IRA is that the distributions will be taxed at the tax rate of the grandchild, which is likely to be lower than that of the grandchild’s parent (your child).
While the stretch and tax benefits are substantial, you have to be careful about how you leave an IRA to a grandchild. You should never name a minor as a beneficiary of an IRA, as it will require a costly and time consuming court process for anyone to get control over the IRA, even the grandchild’s parent. And even if your grandchild is 18 or older, you may not want to name the grandchild as the beneficiary, as he or she will have full control over the IRA and can withdraw the entire balance immediately. Instead, you may consider leaving the IRA to a conduit trust for the grandchild’s benefit that allows the stretch benefits, but also can control the reasons why additional funds are taken from the IRA and when the grandchild should have full access to the IRA. It is important to work with an experienced estate planning attorney in setting up this trust to ensure that RMDs can still be taken over the grandchild’s life expectancy.
Leaving your IRA to your grandchildren, outright or in trust, can provide substantial growth and tax benefits. It is particularly something to consider when your children already have significant assets and do not need the funds, or if your children will be inheriting sufficient funds from you from other sources. There are numerous factors that go into deciding how to designate the beneficiaries of your retirement plans. An experienced estate planning attorney can advise you on the strategy that will work best for you and can give you the peace of mind that your family will be provided for in the most effective and tax efficient way possible upon your passing.