You can name a child as a beneficiary of your individual retirement account, but some thoughtful planning is required to get the most desirable results. If you set it up properly, you can arrange for the IRA distributions to stretch out over the child’s lifetime. You can also take steps to ensure that an adult oversees the distributions until the child comes of age.
The trustee of your IRA must distribute account’s assets to your beneficiaries according to IRS regulations. If you die on or after April 1 of the year following the one you reach age 70 1/2 -- this is the beginning date for required minimum distributions -- your final life expectancy determines the distribution period for non-spouse beneficiaries. If you die before this date, the trustee uses your life expectancy or that of the oldest beneficiary, whichever is longer. That’s the rub. Naming your spouse or some other adult as one of the beneficiaries compresses the child’s distributions into someone else’s life expectancy. Don’t name a non-individual, such as a charity or your estate, as a beneficiary, because this might squeeze the distribution period down to five years.
You can remedy the oldest-beneficiary problem by setting up separate accounts within your IRA. As long as this is in place by the end of the year following your death, the required distributions will depend on each beneficiary's life expectancy, not that of the oldest beneficiary. If you use separate accounts, a minor might receive IRA distributions over many decades. This technique only works if you die before reaching the required beginning date for minimum distributions. You can’t use separate accounts if you make a trust your IRA beneficiary. You can also name separate accounts in a Roth IRA. By converting your traditional IRA to a Roth, your beneficiaries inherit tax-free.
You might not want a minor child deciding how to spend an IRA inheritance. One solution is to set up a custodial account under the Uniform Transfers to Minors Act. You name a custodian to manage the UTMA account until the child reaches the age of majority, typically 18 or 21 years of age, depending on state law. You don’t need court approval to name the UTMA custodian. Tell your IRA trustee to deposit the child’s IRA distributions directly into the UTMA account. Bonus feature: As of 2013, the first $1,000 of income in the UTMA account is tax-free and the second $1,000 is taxed at the child’s tax rate, which is usually low.
Naming a properly drawn “accumulation trust” as your IRA beneficiary allows you to exert more control over distributions. Your trust must take IRA distributions according to the IRS rules, but you can let the money accumulate in the trust until a later time. For example, you can withhold distributions to a minor until she finishes college or weds. The down side of this strategy is that the IRS taxes income earned in a trust at special high rates. Beneficiaries will probably have lower tax rates than those of a trust, so keeping money locked up in a trust might not be tax-efficient.
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