There can be major advantages, but you need to know how to do it
Can You List Minor Children as Your IRA Beneficiaries?
by Gary Foreman
According to an Employee Benefit Research Institute study, the average IRA account balance is over $165k for people aged 60 to 64 and $212k for those aged 65 to 69. And you hope that's enough to last the rest of your life.
But what happens to the balance when you pass away? It goes to your beneficiaries, and how you choose beneficiaries can make a major difference in how much money they actually inherit. This is especially true if you want it to go to children or grandchildren who are minors.
To help us understand the problem and potential solutions, we sought out a financial planning expert. Jason Lina is a CFA, CFP accredited financial planner in Atlanta and St. Simons Island GA.
Q: What rules are there as to who can be the beneficiary of an IRA?
Mr. Lina: Anyone of any age can be named as the beneficiary of an IRA although there are some challenges that come with naming a minor as an IRA beneficiary.
Q: There are certain risks to naming a minor as a beneficiary. What are some of those risks?
Mr. Lina:The law prohibits minors (individuals under age 18 or 21, depending on the state) from owning legal property of any kind in their own name. Moreover, IRA custodians are similarly prohibited from dealing with minors. As a result, naming a minor outright as IRA beneficiary has several potential problems:
1) State court must appoint a guardian or conservator to handle the IRA (or other retirement accounts like a 401k) until the child reaches the age of majority (18 or 21). Aside from the possibility that the court could appoint someone that the IRA owner did not attend, this court process typically results in unnecessary legal costs, which can be as much as $5,000 plus ongoing reporting requirements by the eventual conservator.
2) The more important risk is that the minor beneficiary obtains outright and unencumbered ownership of the retirement account(s) at age 18 or 21, which is generally not the intent of parents or grandparents. There are many bad decisions that an 18 year old can make with a large IRA inheritance.
Q: There are ways to minimize or eliminate the risks of a minor beneficiary. What tools are available to the IRA owner?
Mr. Lina:One option is simply for IRA owners not to name minor IRA beneficiaries. However, this is generally not the ideal option for parents like me with minor children. Instead, IRA owners can name a trust (or trusts) as the IRA beneficiary and then name minors as beneficiaries of the trust(s). There are several different types of trusts that can be used, such as conduit trusts or accumulation trusts, and the differences are important to understand but I won't get into all those details now. I think the key benefit of establishing these trusts is that they allow the IRA owner to appoint a trusted person to oversee the trust and they allow the IRA owner to determine at what ages or under what circumstances the minor can access the IRA funds. A trust also gets the additional benefit of improved asset protection in case the beneficiary ever faces a lawsuit, debt issues, divorce, etc.
Q: Wouldn't it just be easier to let the money go to my estate and let my will leave the money to the kids?
Mr. Lina:You can name your estate or your last will and testament as the IRA beneficiary, but there are some very unfriendly tax consequences. An IRA that has these non-living beneficiaries named has to be paid out over an accelerated period of no more than five years rather than over the lifetime of the intended beneficiary. Remember that for a Traditional IRA, the distributions are treated as income and taxed, so this accelerated payout requirement can be highly detrimental. In the case of a Roth IRA, the tax outcome is generally even worse because the potential for the beneficiary to benefit from tax-free growth over a lifetime is lost.
Q: There's something known as a "stretch Roth IRA." Could you help us understand what it is and how it works?
Mr. Lina: Yes, people occasionally read about this stretch IRA concept and come into our office asking if they can create a stretch IRA. The reality is that "stretch IRA" is not a real legal term or a term that the IRS uses. It is simply a financial planning strategy that many financial advisors suggest to maximize the tax efficiency of inherited IRAs. The term "stretch IRA" refers to an IRA that is distributed over a lifetime based on a table that the IRS provides to help calculate the mandatory distribution at each age. For example, a 30-year old who inherits an IRA can systematically distribute an IRA over the next 53 years rather than distribute everything soon after the inheritance occurs and face a large tax liability. With wise planning, a young beneficiary (i.e. child or grandchild) can exploit the compounding effects of tax deferred or tax freegrowth while effectively creating a lifetime annuity. The tax savings by employing a stretch IRA rather than immediately distributing the IRA can easily be in the millions of dollars for a modest inherited IRA. The problem we encounter is that a young beneficiary inherits an IRA and gets either no advice or bad advice when handling the inherited IRA and does something wrong to destroy the potential stretch option. Once such a mistake is made, there is no fixing it.
Now you didn't ask about this and I won't get too deep into it, but there is a lot of momentum in Washington DC to kill the stretch IRA. The 2015, 2016, and 2017 White House budgets all proposed a mandatory 5-year payout of IRAs. The prevailing argument against the stretch, which has support from both parties, is that IRAs were never intended to be legacy planning accounts. The potential that Congress could kill the stretch IRA does not mean people should ignore it, but it is something to keep in mind.
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Q: Do these strategies only apply to larger IRAs? Or can people with five or ten thousand dollar accounts benefit?
Mr. Lina: It's a good question that we get quite often. The stretch IRA option that I just described exists for anyone and costs nothing to establish. Again, the only important thing is that the beneficiary (or the IRA guardian) understands the rules surrounding inherited IRAs. Creating a trust to serve as IRA beneficiary does have costs, both the legal costs to prepare such a trust (even if the trust is not legally created until death) and costs to administer the trust each year it is in existence. As a result, it often doesn't make sense for someone with a smaller IRA to incur the costs of creating a trust to serve as beneficiary. There's no magic size for when it does or does not make economic sense, but someone with less than $100,000 in retirement accounts may not find economic benefit to using the IRA trust.
Reviewed March 2018
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Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. Gary is available for audio, video or print interviews. For more info see his media page.
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