Leaving an IRA to your grandchildren rather than your children could make it more valuable to your family.
Heirs who inherit IRAs—or 401(k)s, which can be rolled over into IRAs—typically can withdraw money from these accounts slowly over many years, extending the tax-deferred investment growth (or tax-free investment growth in the case of a Roth IRA). But how slowly an heir can withdraw money from an IRA depends on the age of the heir.
The “required minimum distributions” (RMDs)—that is, the amounts that must be withdrawn each year—are based on the heir’s remaining life expectancy. Because grandchildren are decades younger than their parents, they can remove the money much more slowly, maximizing investment growth.
Two more potential benefits of leaving IRAs to grandchildren rather than your children…
Young grandchildren tend to be in lower income tax brackets than their higher-earning parents, so the money they withdraw from the IRA is likely to be taxed at a lower income tax rate. (This applies to traditional IRAs. Withdrawals from Roths typically are not subject to income taxes.)
Leaving IRAs to grandkids keeps these assets out of the middle generation’s estates. Although federal estate taxes are no longer a concern for most families—the federal estate tax exclusion now is more than $5 million—it still could be prudent to keep assets out of your children’s estates if they don’t need the money and live in states with low state estate tax exemptions…or if one or more of your children seems likely to get a divorce.
IRA assets do not need to be reported on college financial-aid applications, so leaving an IRA to school-age grandchildren should not interfere with their ability to obtain loans. (The RMDs that a grandchild is required to take each year are reported as income on these applications but usually are not large enough to have a major impact on financial aid.)
Two potential ways to leave IRAs to grandkids…
Name your grandkids as beneficiaries of the IRA. This is the easiest solution. You can avoid having to update your beneficiary designations each time a new grandchild is born by writing “any children born of my children or adopted by them,” rather than listing each grandchild by name on the IRA beneficiary-designation form. If some of your grandchildren still are minors, instead list a trusted adult “as custodian for the benefit of” these grandchildren. Otherwise a court likely will appoint a custodian, which could be costly for your estate.
Downside of naming your grandkids as beneficiaries: Your grandchildren will gain total control over inherited IRA assets as soon as they reach the age of majority—18 or 21 in most states—which still may be too young for them to act responsibly.
Name a trust as your IRA beneficiary…and your grandkids as beneficiaries of that trust. This lets you maintain some control over IRA assets even after you’re gone. The trust might allow grandkids to make large withdrawals from the IRA only after they reach a certain age, for example, or only for specific purposes, such as to pay college bills.
Downside: Setting up and maintaining this trust are likely to cost at least a few thousand dollars…the youngest of your grandchildren could face stiffer RMD requirements than if you left the IRA to them directly, because of special RMD rules governing trusts…and if the trust documents are not drafted in careful compliance with complex IRS rules, your grandchildren might be forced to withdraw all of the money from your IRA within five years.
