Do You Want to Leave an IRA to Your Grandchildren?

Dear Carrie,

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 Distribution requirements would be?

—A Reader

Dear 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 have options about when and how to withdraw the money.

However, it's not quite as simple as just naming them as the beneficiaries, for a few reasons. First, as you mention, the distribution rules can be complicated and each beneficiary may have different needs on when it would be best to distribute the assets most effectively. 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.

Grandchildren generally won’t be subject to RMDs—but they will have to distribute the assets within 10 years

Prior to the passage of the SECURE Act that became effective as of January 1, 2020, most heirs used to be able to distribute Inherited IRA assets over the course of their lifetime—with the caveat that they had to take RMDs. However, under the new law, only certain types of beneficiaries have this option, and grandchildren are not one of them (unless they are disabled or chronically ill).

Grandchildren generally fall under the category of ‘Designated Beneficiary,’ which means that they can distribute the assets however they like, without RMDs each year—as long as all assets are distributed within 10 years. In other words, your grandchildren can take some assets out each year or just leave all the assets in the account until the last day. However, any assets that are not distributed by the end of the 10th year will be subject to a 50% penalty.

How the assets are distributed within that timeframe could have important tax considerations, so it’s best to consult with a tax advisor. Because of the SECURE Act rules, if you are married, in some cases it may make more sense to name your spouse as the designated beneficiary to take advantage of spreading the distribution over his or her lifetime and then they can name your grandchildren as beneficiaries.

Unless your IRA is a Roth, the grandkids 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 or they can wait until the five years holding period has passed to receive tax-free distributions.

Three 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. Lastly, the inheritance may have an impact on student financial aid considerations for your grandchildren. Consider all of these issues into your overall plan.

Run this by an advisor

Naming a grandchild as an IRA beneficiary can be a 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.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.