Grandparents may be tempted to leave an IRA to a grandchild because children have a low tax rate- but the “kiddie tax” could make doing this less beneficial.
An IRA can be a great gift for a grandchild. A young person who inherits an IRA has to take minimum distributions- but because the distributions are based on the beneficiary’s life expectancy- grandchildren’s distributions will be small and allow the IRA to continue to grow. In addition- children are taxed at a lower rate than adults—usually 10 percent.
However- the lower tax rate does not apply to all unearned income. Enacted to prevent parents from lowering their tax burden by shifting investment (unearned) income to children- the so-called “kiddie tax” allows some of a child’s investment income to be taxed at the parent’s rate. 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 income is taxed at the parent’s rate- which could be as high as 35 percent. The kiddie tax applies to individuals under age 18- individuals who are age 18 and have earned income that is less than or equal to half their support for the year- and individuals who are age 19 to 23 and full-time students.
If a grandparent leaves an IRA to a grandchild- the grandchild must begin taking required minimum distributions within a year after the grandparent dies. These distributions are unearned income that will be taxed at the parent’s rate if the child receives more than $2-100 of income (in 2017). In addition to IRAs- the kiddie tax applies to other investments that supply income- such as cash- stocks- bonds- mutual funds- and real estate.
If grandparents want to leave investments to their grandchildren- they are better off leaving investments that appreciate in value- but don’t supply income until the investment is sold. Grandparents can also leave grandchildren a Roth IRA because the distributions are tax-free.
For more information about leaving an IRA to grandchildren from Kiplinger– click here.