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How Best To Leave IRAs To Your Grandchildren

Would you like to set aside money for your young grandchildren?  One way to do that without giving up control over the assets is to leave one or more of your IRAs to the grandkids.  If you handle things correctly, the youngsters have to take only minimal distributions during their lifetimes, enabling the funds to grow and compound for decades.
 
But you still have obstacles to overcome.  Significantly, a minor child can't inherit and IRA outright.  As an alternative, you generally can designate either a grandchild as the beneficiary of your IRA and appoint a custodian to oversee the account, or you can leave the IRA to a trust. With the latter, you can still dictate how the money will be used after you pass away.
 
Let's take a closer look at these two main options.
 
1.  Name the grandchild as the IRA beneficiary. Typically, you might appoint one of your grandchildren's parents - your son or daughter - as custodian for the account.  Also, remember to name a backup in the even your first choice is unable to serve.  Fail to make contingency plans and the entire matter may end up in court, with whoever is seeking guardianship for the IRA having to ask to be appointed as custodian.
 
If you're going this route, check with the financial institution or brokerage firm holding the IRA to make sure it permits minors to be named IRA beneficiaries.  Not all companies do, but it's relatively easy to move the funds to an institution that does allow it.
 
This arrangement can be simple and effective, but there's one potential downside.  Once grandchildren reach the age of majority (usually 18 or 21) in the state where they live, the money is legally theirs.  Instead of investing the funds over the long term as you envisioned, the grandchild might rush out and buy a Range Rover or splurge on exotic vacation.
 
2.  Name a trust as the IRA beneficiary. This may be the optimal approach if you're concerned that a young beneficiary will squander the money.  All you have to do is set up a trust (the fees generally are reasonable), designate it as the IRA beneficiary, and choose a grandchild as the beneficiary of the trust.
 
This will give you greater control.  For instance, with a trust you can dictate when the money can be spent or what it can be spent on.  In addition, the trust terms could require the grandchild to take distributions over his or her life expectancy, or the trust could dole out specified amounts on a predetermined schedule.
 
Note, however, that a trust likely won't proved any tax benefits.  Investment earnings will be taxed to the trust while the funds accumulate, and the annual tax rate for the trust frequently will be higher than the rate a youngster would have paid.  For 2014, a trust with an income of $15,000 a year is in the 39.6% tax bracket, while the grandchild would pay a maximum rate of only 15%.
 
To avoid that problem, you could convert some or all of your traditional IRA funds into a Roth IRA.  This conversion is subject to current tax, but this may ensure future tax-free payouts.
 
Time Is On Your Side
 
No matter which method you use, time is a valuable ally.  Heirs of both traditional and Roth IRAs can stretch the tax advantages by taking "required minimum distributions" (RMDs) over their life expectancies. While distributions from a traditional IRA are taxable, payouts from a Roth IRA are tax-free.
 
Because of differences in life expectancy, a younger heir will have to with withdraw less money than an older one.  For example, the first RMD for a 10-year-old inheriting a $200,000 IRA that grows 6% a year would be around $2,950.  In comparison, a 20-year-old inheriting that IRA would get an initial RMD of about $3,400.  The amount that must be withdrawn increases each year, but it will be small enough that much of the account can continue to grow.
 
Like your own RMDs, these are based on both age and account balance.  Going back to the previous example of the 10-year-old, the second distribution would increase about $3,130.  By the time that heir turns 68, assuming the same 6% annual growth, the account would be valued at roughly $1.3 million, with an RMD of about $89,560.  Of course, these figures are hypothetical and not indicative of any particular investment.
 
Finally, if you've made nondeductible contributions to an IRA, keep detailed records of those contributions. When the contributions are withdrawn, they aren't taxable, but the paperwork may be needed to prove it. Otherwise, you heirs could end up paying tax they don't actually owe.
 
It may be wise to divide up IRAs based of the respective ages of grandchildren.  Consider all your options carefully.  We're available to provide guidance.  


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