Designating a Minor as an IRA Beneficiary

People often bequest assets to minors upon their death, but is designating a minor as an IRA beneficiary a good idea? The age of the person you designate as beneficiary of your IRA will determine the conditions under which they receive the property. Here are some advantages and potential pitfalls of leaving an Individual Retirement Account (IRA) to a minor.

Why Choose a Minor as an IRA Beneficiary?

Many donors choose to bestow an IRA to a minor beneficiary since IRAs provide much greater flexibility than other assets such as savings bonds. Also, inherited IRAs do not have to be used for higher education or any other specific purpose to escape taxation.

Legislation Affecting Minor Beneficiaries

Under the SECURE Act of 2019, the requirements for inherited IRAs changed considerably. According to the Internal Revenue Service (IRS), the SECURE Act requires the entire balance of the IRA account to be distributed within ten years.

There is an exception for a surviving spouse, a child who has not reached the age of majority, a disabled or chronically ill person, or a person not more than ten years younger than the employee or IRA account owner. These five exceptions are considered eligible designated beneficiaries (EDBs), a unique classification of retirement account beneficiaries created by the SECURE Act.

Therefore, most beneficiaries of an IRA are no longer permitted to stretch the required minimum distributions (RMDs) over the beneficiary’s life expectancy. The Stretch IRA was an estate planning strategy used when an account owner passed away in December 2019 or prior. It was once practical to leave IRAs to allow more time to let their inherited funds grow while taking required minimum distributions RMDs.

10-Year Rule

As of January 2020, the value of the IRA must be distributed to most beneficiaries by the end of the 10th calendar year following the year of the employee or IRA owner’s death. Under the 10-year rule, there is no longer an RMD amount required annually, as long as the funds are fully depleted at the end of the 10th year.

For example, a beneficiary could withdraw a consistent amount every year for ten years, a varied amount every year, or wait until the final day to withdraw the entire balance, including any gains made over the ten years. Additionally, according to the IRS, the new 10-year rule applies regardless of whether the participant dies before, on, or after the required beginning date (RBD), now age 73.

The SECURE 2.0 Act of 2022 changed the required minimum distribution age to 73 from 72, effective January 1, 2023, and the age increases to 75 in 2033. 

An Exception to the 10-Year Rule

One exception applies to the 10-year rule for a child beneficiary who has not yet reached the age of majority, commonly between ages 18 and 21, depending on the state where the minor resides. This exception applies only to the account owner's child.

The owner's child below the majority age can withdraw from an inherited retirement account using their life expectancy. However, once the minor reaches the age of majority, the 10-year rule relating to withdrawal requirements for a designated beneficiary begins, and the beneficiary would have until Dec. 31 of the 10th year following their majority age birthday to withdraw all funds from the inherited retirement account.

Examples of Inherited IRAs

Alex, a single parent of one, passed away. His eight-year-old son, Timmy, is the sole beneficiary of a $1.5 million IRA. Timmy qualifies for the special treatment of an eligible designated beneficiary as Alex's child. Timmy will have a minimum of 20 years (18 years - 8 years + 10-year limit) and a maximum of 28 years if obtaining a qualified higher education (26 years - 8 years + 10-year limit) to withdraw all the funds from the inherited IRA.

Beverly designates her 10-year-old granddaughter, Robin, as the sole beneficiary of her $2 million IRA. If Beverly passes away, Robin, who is not the account owner's child, is considered a designated beneficiary and is subject to the 10-year rule and will have to withdraw all funds from the account over the next ten years.

Issues With Ownership

Common law dictates that legal measures must be taken to protect minors in inheritance. Minors cannot own legal property and are often appointed a guardian or conservator to manage the property on their behalf until they reach the age of majority. If a guardian is not designated before the timeframe for an inheritance, the court will appoint one for the minor.

The law prohibits IRA custodians from dealing directly with minors in any capacity.Having a will not rectify this problem since a will only deals with probate assets, and IRAs are exempt from probate.

Options for the IRA

There are several ways that your beneficiary can receive an inherited IRA.

Custodial account

A custodial account, such as a UGMA or a UTMA account, is an option but there could be adverse tax consequences for the minor’s guardians, who may claim the child as a dependent on a tax return. The minor’s income may affect the guardian's tax bracket and marginal tax rate.

A custodial account also gives the minor custody of the property at the age of majority, when many young adults are not ready to handle a large sum of money. Additionally, UGMA/UTMA funds do not have to be used exclusively for higher education purposes.

529 plan

Another possible solution is to put the money into a 529 plan, which allows the assets to grow tax-free until they are used to pay for qualified higher education expenses. However, the minor may eventually decide not to pursue higher education.

Accumulation and Conduit Trusts

It is possible to substitute a revocable living trust as the beneficiary for the IRA, with the minor listed as the beneficiary for the trust and the guardian appointed as the trustee. A trust allows you to provide specific instructions on how you want the guardian to handle the IRA distributions for the minor.

A conduit trust would siphon the distributions directly from the IRA to the minor so that the trust is not taxed.

If the minor has special needs, an accumulation trust may be appropriate. Although this arrangement keeps the money inside the trust to be taxed at higher trust rates, it also ensures that the money will be used for the minor’s benefit, conceivably even in adulthood.

The Bottom Line

There are several alternatives to leaving your IRA to a minor beneficiary. The minor's relationship with you now impacts the timing of beneficiary withdrawals and the ability to access the funds.

Check with your IRA custodian to see what its requirements are regarding this matter. If your wishes cannot be fulfilled through mere beneficiary designations or guardian appointments, consider using a trust to ensure that the minor receives the IRA distributions in the manner you specify.