13 Dec 2018
Often, IRAs represent the largest assets in an estate. They are more than just a stash of cash. They carry the gift of tax deferral. If things are done right, this deferral can continue for your child’s life. If things are not done right, your child can lose out on the rare opportunity for tax-advantaged growth.
According to a recent study, over 90% of people who inherit an IRA will cash it out. We don’t want your children to be in that group. A financially savvy child will smartly withdraw what’s needed to pay off college loans or buy a home for his growing family, and leave the rest invested. An inherited IRA is truly a gift that keeps on giving.
Some background An IRA beneficiary is subject to income tax on a distribution. A 10% penalty can also apply to distributions taken prior to attaining age 59½. A 30-year-old child who inherits the IRA is not subject to the 10% early withdrawal penalty. In fact, the early withdrawal penalty doesn’t apply to beneficiaries. IRA owners must begin taking required minimum distributions (RMDs), based on their life expectancy, the year after they turn 70½. The concept of RMDs also applies to IRA beneficiaries.
CHILDREN AS BENEFICIARIES You can name a child as your IRA beneficiary on a form provided by the financial firm or bank. You can name one or more children. Each beneficiary can take a lump sum distribution and close out the IRA. However, your children will have three better choices, all of which afford some tax deferral:
1) They can begin RMDs in the year after the IRA owner’s death, based on their own life expectancy, as calculated based on their age. This yields maximum tax deferral.
2) If the IRA owner dies after age 70½, the child also has the option to calculate RMDs based on the IRA owner’s life expectancy. This enables a child to withdraw more funds earlier.
3) If the IRA owner dies before reaching age 70½, a child can opt to take the distribution over five years, which ends no later than December 31 of the fifth year following the IRA owner’s death.
MULTIPLE CHILDREN AS BENEFICIARIES One IRA left to several children can be divided into separate shares no later than December 31 of the year following the IRA owner’s death. RMDs will be based on each child’s life expectancy. If the IRA owner was due to take a RMD in the year of death and didn’t, it must be paid to those who inherit the IRA. Failure to do so results in a 50% penalty on the RMD amount.
An IRA can also be left to children in an IRA trust, which must be irrevocable and have identifiable beneficiaries at the time of the IRA owner’s death. A class such as “my living children” names identifiable beneficiaries, whereas a class such as “my grandchildren” may not. For an IRA trust, additional paperwork confirming the trust terms must be given to the IRA custodian no later than October 31 after the year of the owner’s death. An IRA trust can limit distributions to RMDs and is a good idea for children who can’t manage their money.
SOME POINTERS Only trustee to trustee transfers can be made to transfer the owner’s IRA to the beneficiary. Once IRA funds are paid to a beneficiary, they are taxed. They cannot be put back in an IRA. Note too that your child’s creditors can reach assets in an inherited IRA.
FINAL ADVICE The inherited IRA rules are so complicated that frontline employees in a bank or investment firm often do not know them. You can avoid costly mistakes by having a knowledgeable investment advisor, accountant or attorney on your team who can shepherd your children to make the best decisions