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 rates higher than the usual rates for unmarried individuals. For 2018, the first $2,100 of unearned income is tax-free. Any additional income is taxed using the brackets and rates for estates and trusts, which could be as high as 37 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 and whose earned income is less than or equal to half of their support for the year. The kiddie tax does not apply if the child's parents are both deceased or if the child is married and files a joint return with his or her spouse.
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 rates for estates and trusts if the grandchild receives more than $2,100 of income (in 2018). 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.
For information about inherited IRAs, click here.