Parents who have an IRA are concerned with the possibility that they will die simultaneously and the IRA will be left to their children. Another issue is that the single parent or the surviving spouse may only have minor children who would be beneficiaries of the estate. In some cases, parents or grandparents may want to leave IRA accounts to minor children to provide flexibility and long term growth. Deferring income taxes until distribution of the IRA allows maximum tax deferred growth of assets.
Problems with Distribution of IRA Accounts to Minor Children
Planning for the distribution of the IRA is designed to provide for a required minimum distribution (“RMD”) over the longest possible time so that tax deferred growth of assets is achieved. Under the internal revenue code the RMD time period is calculated to pay out over the designated beneficiary’s lifetime.
There are certain problems that must be addressed in an estate plan when minor children are to receive the benefits of an IRA. First, if the IRA assets are left to a minor child, a conservator will have to be appointed. Parents must appoint a conservator and the court will have to approve the person. There is no guarantee that the court will appoint the person(s) you have designated. You will have to appoint this person because IRA custodians are prohibited from dealing directly with minors in any capacity. Providing for a person in the Will does not solve the problem because your Will deals with assets subject to probate and IRA assets do not go through probate. Second, you will have to decide how to leave your IRA depending on when you want your minor child to have access to the entire fund. Separate trusts can be established, or a single trust could be split in shares. How the trust is set up effects how the measuring life for RMD is determined.
When Does A Minor Have to Start Taking the RMD?
Unlike an IRA left to a spouse, a minor child does not have the option to roll over an IRA into their own IRA. A minor child will have to begin taking RMDs soon after the parent’s death. The RMDs will be calculated over the lifetime of the oldest beneficiary based on her age and the beneficiary will have to pay income tax on the distributions. In addition, retirement assets passing to minors are included in the decedent’s estate.
Options for Your Children When Inheriting Your IRA
If the IRA assets are left to the minor child through a conservator, the distributions can be placed in a Uniform Gift to Minor custodial account. The downside is that the minor can have access to the entire account at 21.
Another alternative is a 529 College Fund Plan. This will allow the funds to grow tax free until they are used for college. This planning can fail if the child decides not to attend college.
A third option is a trust. The conservator could be your trustee. The trust will provide specific instructions as to how you want the conservator/trustee to handle the IRA distributions to the minor child.
Complications of Using a Trust
Only individuals may be designated beneficiaries. When a trust is the beneficiary, the IRA proceeds must be paid out over the lifetime of the oldest beneficiary of the trust. This is not a rollover IRA. The trust must be carefully structured to insure that the parents’ wishes are carried out. While the trustee may want to make only RMDs over an extended period of time, using a conduit trust will require the trustee to remove the RMD each year from the trust. A conduit trust requires that all distributions from the IRA are paid out currently and nothing is accumulated in trust. In the case of a minor the trust will last to a certain age whereupon the trust will terminate and the assets will be distributed to the child. If there are multiple beneficiaries of the trust, then the designated beneficiary will be the oldest child, with RMDs determined by that beneficiary’s life expectancy. The tax advantage is that the trust usually pays a higher tax rate than the child and, thus, the transfer will reduce the income tax on distributions.
The Five Year Distribution Problem
The five year distribution rule can come into play if the beneficiary of the trust does not live to the designated age of distribution. For example, suppose under the provisions of the trust, the IRA assets are held in trust to a specific age. If the child is living at that age, she gets the assets. If she is not living at that age, the assets could go to the settlor’s remaining heirs or perhaps to her grandparent who is in his seventies. This will result in the required minimum distributions to be calculated based on the grandparent’s life expectancy.
Even if the trust required that trust assets be distributed to the child’s estate upon her death, this could result in a five year payout because the child’s estate is not an individual. This would make the child’s estate the sole beneficiary of the trust. A better option is to designate a specific individual as the contingent beneficiary, preferably someone of equal or younger age, such as one of the other minor children. To achieve this result the distribution to the other child must be outright. This could create a problem, if the other child is still a minor.
As discussed above, one solution is the use of a conduit trust. The conduit trust allows distribution of RMDs for the benefit of the minor child so that the trust is not taxed and the child beneficiary of the trust is considered by the IRS as the designated beneficiary. If the trust is properly structured, then the minor child will be the designated beneficiary and the assets can continue to grow based on her life expectancy. As to the distributions to the minor, consideration should be given on how the distributions can be made and meet the requirement that they are paid directly to the minor. The trust instrument should include a provision requiring distributions be either paid to or for the benefit of the minor.
The greatest possible tax deferral is through the use of a conduit trust for each minor beneficiary. However, there may be other reasons, such as qualifying for special needs or asset protection that suggest a different solution. Each family situation must be examined to determine the most appropriate approach to planning for IRA assets.