People often leave assets to minors, but is making a minor an IRA beneficiary a good idea? After all, there are many ways to give assets to those for whom you wish to leave a legacy. You can leave tangible assets, such as cars, houses, or other belongings—or liquid assets, such as cash or securities.
However, the age of the person to whom you leave these assets will often determine the form of and the conditions under which they receive the property. Here are some of the advantages and potential pitfalls of leaving an Individual Retirement Account (IRA) to a minor.
- The minor beneficiary's relationship to you now has a large impact on the timing of distributions.
- The account owner's minor child receives special treatment: That child has until the age of majority for the 10-year window to start, in which all funds must be depleted from the inherited account.
- Other related and unrelated minor beneficiaries are required to fully distribute the balance out of an inherited IRA over no more than 10 years.
- A trust can be beneficial to ensure that the minor receives the IRA distributions in the manner you specify.
Why Choose a Minor as an IRA Beneficiary?
There are several reasons why a donor might choose to bestow an IRA upon a beneficiary who has not yet attained the age of majority. One of the most obvious is that IRAs can provide much greater flexibility than, for example, savings bonds. Also, inherited IRAs do not have to be used for higher education or any other specific purpose in order to escape taxation.
Important Legislation Changes Affecting Minor Beneficiaries
Note that under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in December 2019, the requirements for inherited IRAs have changed considerably. According to the Internal Revenue Service (IRS), "the SECURE Act requires the entire balance of the participant's account be distributed within 10 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 10 years younger than the employee or IRA account owner." These five exceptions are considered to be eligible designated beneficiaries (EDBs), a unique classification of retirement account beneficiaries created as a result of 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 a common estate planning strategy used when an account owner passed away in December 2019 or prior. It made good sense to leave IRAs to minors because their remaining life expectancy was longer, so they would have more time to let their inherited funds grow while taking RMDs.
As of January 2020, amounts held by the plan or IRA must be distributed by 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 in any one year, 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 10 years, a varied amount every year, or wait until the final day to withdraw the full amount (plus any gains made over the 10-year period). 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 72."
An exception to the 10-Year Rule
However, as noted above, there is an exception to the 10-year rule for a child beneficiary who has not yet reached the age of majority—typically between ages 18 and 21, depending on the state. For the sake of simplicity, we'll use age 18 in the rest of the article. The exception to the 10-year rule is in place for the account owner's minor child only (not their grandchild or other related or unrelated minor).
The owner's child who has not reached 18 years of age is permitted to make withdrawals from an inherited retirement account using their own life expectancy. However, once a minor child reaches age 18, they are no longer considered to be an EDB. At that point, the 10-year rule relating to withdrawal requirements for a designated beneficiary kick in, and the beneficiary would have until Dec. 31 of the 10th year following their 18th birthday to withdraw all funds from the inherited retirement account.
A deceased retirement account owner's minor child may get an extension, up until age 26, for the 10-year rule to go into effect, provided the child is pursuing a specified course of education.
Examples of an Inherited IRAs
In March 2020, Tim, a single father of one, passed away. He designated his eight-year-old son, Timmy, as the sole beneficiary of his $1.5 million IRA. Timmy qualifies for the special treatment of an eligible designated beneficiary, as Tim'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.
Alternatively, let's assume Beverly designates her 10-year-old granddaughter, Olivia, as the sole beneficiary of her $2 million IRA. Beverly passes away in January 2021. Olivia—because she is not the account owner's direct child—is considered to be a designated beneficiary and is therefore subject to the 10-year rule. She will have to withdraw all funds from the account over the next 10 years.
Issues With Ownership
Common law dictates that certain legal measures must be taken to protect minors in circumstances like this. Minors cannot own legal property of any kind in their name. One way around this is to appoint a guardian or conservator to manage the property on their behalf until they reach the age of majority. Appointing a guardian is your responsibility. If you do not do this, the court will appoint one for you—and that could be someone who may have very different ideas about how the account should be managed and invested.
Leaving an IRA to a minor requires the appointment of a guardian to manage the account until the child reaches adulthood.
There is no escaping this appointment, as the law prohibits IRA custodians from dealing directly with minors in any capacity. A will alone will not rectify this problem for you because a will only deals with probatable assets, and IRAs are exempt from probate.
One of the minor’s parents or another relative can petition the court for guardianship if you make no appointment, but this can be costly, time-consuming, and in the end, totally unnecessary. It can also become a protracted legal battle if the minor’s parents have divorced, and both seek custody of the account.
Options for the IRA
There are a few different ways that your beneficiary can receive the IRA.
One option is to put the distributions inside a custodial account, such as a UGMA or a UTMA account. However, there could be adverse tax consequences for the minor’s guardians (whoever claims the minor as a dependent on a tax return) if the minor’s income is above a certain level since the guardian must pay tax on the excess at their top marginal tax rate.
This also gives the minor sole custody of the property at the age of majority, an age at which 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.
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, if the minor decides not to pursue a college education, this plan can backfire.
Accumulation and Conduit Trusts
A more comprehensive (albeit expensive) solution may be to substitute a revocable living trust as the beneficiary for the IRA, with the minor listed as the beneficiary for the trust. The guardian would then be appointed as the trustee. One benefit is that a trust allows you to provide specific instructions as to how you want the guardian to handle the IRA distributions for the minor.
There are several types of trusts that you can use to this end. A conduit trust would siphon the distributions directly from the IRA to the minor so that the trust is not taxed (a situation you want to avoid whenever possible, as trust tax rates are currently among the highest).
If the minor has special needs, an accumulation trust may be appropriate. Although this arrangement does keep 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 after he or she reaches adulthood.
The Bottom Line
There are several alternatives to choose from if you wish to leave your IRA to a minor beneficiary. The minor's relationship to you now has a large impact on the timing of beneficiary withdrawals and their 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, then consider using a trust to ensure that the minor receives the IRA distributions in the manner you specify.