You might know that a Roth IRA is a way to grow your nest egg without any future tax payments on withdrawals. But it also can be a smart way to contribute to your grandchildren’s financial future.
There are better and worse ways to use a Roth IRA for a grandchild, though. Here’s what grandparents need to know…
Name grandchildren as beneficiaries of one or more of your own Roth IRAs on a form provided by the financial firm. If there is more than one grandchild, you need to list the percentage of the Roth that each will receive. If the grandchildren are minors, you also need to designate a custodian who will oversee the accounts after your death until they reach adulthood, typically age 18 but sometimes 21, depending on the state.
Advantage over a traditional IRA: Although the IRS will require your grandchildren to take annual withdrawals (known as required minimum distributions, or RMDs) from the Roth starting in the tax year they inherit it, the Roth withdrawals are tax-free. RMDs usually are minimal at first, ranging from 1.2% to 2% a year up to age 33, for instance, based on how many more years your grandchildren would be expected to live.
Caution: Don’t leave a Roth to a grandchild in your will instead of on the beneficiary form. If you make this mistake, your estate or your spouse could automatically be designated as the beneficiary, depending on the rules at the financial firm. For that to be changed after your death, a probate court would have to review the case. And although the grandchild would probably be granted your Roth, he/she would have “nondesignated” beneficiary status. That means that under IRS rules, instead of stretching out the withdrawals, the grandchild might have to withdraw all assets within five years after the end of the year in which you died—potentially losing thousands in tax-free investment gains.
Safeguard: If you worry that an adult grandchild might withdraw and spend the money frivolously, have an estate attorney establish a trust for the child with your specific instructions. Designate the trust as the beneficiary of your Roth IRA.
Contribute to your grandchild’s existing Roth IRA—or create a new one in the grandchild’s name if he has earned income. If the child is a minor, you or a parent might act as custodian of the child’s account, overseeing the account and any investment decisions. You also should name a backup custodian.
Advantage over leaving your own Roth to the grandchild: The child never has to take RMDs.
Disadvantage: You can contribute to a grandchild’s Roth only up to the amount of his earned income that year—and not at all if there is no earned income, so this is probably not a good option if you want to use the Roth to help fund your grandchild’s college expenses.
Note: There are annual limits on total contributions to one or more IRAs for any individual IRA owner, whether they’re your own IRAs or your grandchild’s. For 2016, that’s $5,500, plus an extra $1,000 if the IRA owner is age 50 or older.
