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.
Before enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019, an IRA was a great gift for a grandchild. A young person who inherited an IRA could take distributions based on their life expectancy, meaning the grandchild's distributions would be small and allow the IRA to continue to grow. The SECURE Act requires that most non-spouse beneficiaries of an IRA withdraw all the money in the IRA within 10 years of the IRA holder’s death. This means that an IRA is not quite as great a gift to a grandchild as before, but children are still taxed at a lower rate than adults—usually 10 percent -- making it still worthwhile in many cases.
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 2022, the first $1,150 of unearned income is tax-free, and the next $1,150 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, due to the SECURE Act the grandchild must take all assets within 10 years of the grandparent's death (unless the grandchild is disabled or chronically ill, in which case they can take distributions over their lifetime). These distributions are unearned income that will be taxed at the parent's rate if the child receives more than $2,300 of income (in 2022). 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. Also, to ensure that your gift goes to whom you want it to and is not squandered in ways you might not want, consider making the IRA payable to a trust.
For more information about leaving an IRA to grandchildren, click here.
For information about inherited IRAs, click here.