Tax Trap Snares Young IRA Heirs

Leaving a traditional IRA to a young grandchild sounds like the perfect idea. The young heir would have to take taxable distributions, but really, how high could the tax rate be for, say, a toddler or preteen? Not so fast. A quirk in the tax code can easily cause this apparent slam-dunk to barrel right out of the basket--leaving the majority of each year's payout to be taxed at the parents' higher rate.

Enter the "kiddie tax," which applies to unearned income (and distributions from traditional IRAs fall in that category) of children under age 18, or up to age 24 if the child is a full-time student. For 2017, the first $1,050 of unearned income is tax-free, and the next $1,050 is taxed at the child's rate. Any additional unearned income is taxed at the parent's rate.

When a minor grandchild is bequeathed an IRA, required minimum distributions must be taken out starting the year following the original owner's death to keep the tax shelter going. But the child's long life expectancy means the factor from IRS Publication 590-B used to calculate the IRA RMD would be high. That holds down the amount that must be distributed annually, so more money can stay in the account to grow tax-deferred.

Let's say you leave a $300,000 traditional IRA to a 10-year-old. The young heir's first RMD would be $4,121. Let's assume the child's tax rate is 10%, and the parent's tax rate is 25%. Before the kiddie tax, the distribution would have been tax-free, protected by the child's exemption and standard deduction.

But because a young heir's required minimum distribution is subject to the kiddie tax, there is no personal exemption and the standard deduction is capped at $1,050. So, the first $1,050 is tax-free, the next $1,050 is taxed at 10% for a bill of $105, and the remainder is taxed at the parent's rate--creating $505 of additional tax. The kiddie tax claims a total of $610, or about 15% of the payout.

Leaving a Roth IRA Versus Traditional IRA

You could escape the kiddie tax by passing a Roth IRA to a minor grandchild, which may seem like a more attractive move. While nonspouse beneficiaries also have RMDs from inherited Roth IRAs, those distributions are tax-free. And a young heir can potentially enjoy decades of earnings in the Roth IRA to grow free from Uncle Sam's clutches--seemingly another slam-dunk.

But this sure shot is likely to miss, too: Those tax-free distributions can be more tax-effective if a parent inherits the Roth IRA. "Generally, if you are making the choice between tax-free and taxable, think about giving the Roth to the person with the higher marginal rate," says Maria Bruno, senior investment analyst for Vanguard's Investment Strategy Group. By leaving the traditional IRA to the grandchild, Bruno says, "you stretch out the RMDs and benefit from the kiddie tax rules."

Even with the kiddie tax, a minor grandchild's smaller RMDs are taxed at a lower rate than if the parent inherited the traditional IRA. Left to a 40-year-old adult child, the RMD for the traditional IRA in the example above would be about $6,881. At a 25% tax rate, the heir's tax bill would be about $1,720 on the RMD--$1,110 higher than the minor's tax bill.

Furthermore, children eventually age out of the kiddie tax. "Once they hit those [age] thresholds, they are their own taxpayer and the tax on the IRA distribution will probably fall," says Tim Steffen, director of financial planning at Robert W. Baird & Co. The child would pay tax on the RMD at his own ordinary-income tax rate, which is likely to be low early in his career.

And children under those age limits who are no longer dependent on their parents are also clear of the kiddie tax. "If a child is 23, files on his own and the parents don't claim him as a dependent, then kiddie tax doesn't apply," says David Levi, senior managing director in the Minneapolis office of CBIZ MHM, an accounting services provider.