What is the best way to leave an IRA or 401(k) account to a minor?

The best way to leave an IRA or a 401(k) account to a minor is to either designate a custodian to administer the account for the minor or leave it to a special trust for the benefit of the minor. Which of these options is best for you depends on your financial situation and goals.

Tax Rules for Inherited Retirement Accounts 

Just as special tax rules apply to retirement accounts during your life, other tax rules apply to these accounts when they are passed on to a beneficiary. As during your life, assets held in an inherited retirement account grow free of tax. When funds are withdrawn from the account, they are subject to income tax at the beneficiary’s ordinary income tax rate.

The longer the funds remain in the account, the greater the savings from tax-deferred growth. For this reason, it is usually best to postpone distribution of the funds for as long as possible. Of course, the beneficiary cannot leave funds in the account indefinitely. There are rules that establish when the funds must be withdrawn from an inherited retirement account.

A beneficiary who is not the account owner’s spouse generally must begin taking distributions from the account the year after the account owner’s death. The amount required to be withdrawn each year depends on the beneficiary’s life expectancy. Very generally, a beneficiary with a remaining life expectancy of 50 years must withdraw 1/50 of the original account balance each year. The amount required to be withdrawn is referred to as a Required Minimum Distribution (RMD). This rule is particularly beneficial for minors because it allows them to stretch the tax deferral of an account over a longer period than older beneficiaries.

Options for Leaving a Retirement Account to a Minor

Children under the age of 18 are not legally capable of managing their own assets, so any assets (including retirement accounts) left directly to a minor are subject to court supervision. The court appoints a guardian or conservator to administer the assets for the benefit of the minor until the minor turns 18.  The guardian must file annual reports with the court with information about the value of the assets being held for the minor and how the assets are being spent, e.g., $5,000 for daycare, $1,000 for clothing, etc.  Because of the administrative burden and the lack of privacy of this arrangement, naming a minor as a beneficiary of a retirement is not recommended.

There are two alternatives to naming a child as a direct beneficiary of a retirement account. First, you can name an adult (a custodian) to administer the account until the minor turns 18. Alternatively, you can name a trust for the benefit of the minor.

Naming a Custodian to Administer a Retirement Account for a Minor

The custodian option is the easiest and cheapest way to avoid court involvement.  It allows you to name an adult (the custodian) to administer the account for the benefit of the child until the child turns 18. When the child turns 18, the account is legally theirs, and they can spend the money however they choose. A custodianship is a good option when the account does not hold substantial funds and when the account is not being divided among multiple children.

Consult with your administrator of your retirement account about the proper language for naming a custodian.

Leaving a Retirement Account to a Trust for the Benefit of a Minor

A trust is more expensive, but it provides the following benefits that are not available with the custodian option:

1. A trust allows you to choose the age at which you’d like the beneficiary to have unrestricted access to the funds in the account.  If you were to choose someone to make smart decisions with a large amount of money, an 18-year-old would likely not be your first choice.  With a trust, you can restrict the beneficiary’s access to the money until the child is 28 or 30, or whatever age you think the child is likely to be mature enough to manage a large sum of money.

2. The trust provides flexibility to make distributions to more than one beneficiary.  If you have two children and leave 50 percent of your retirement account to one child and 50 percent to the other child, with the account to be administered by a custodian, assets allocated to one child cannot be used for the benefit of the other child.  This could pose a problem if one child is in an accident or becomes ill, resulting in significant medical expenses that deplete that child’s account.  If the account were held in a trust for the benefit of both children, the trustee could adjust the spending in accordance with each child’s needs.

3. Funds in a trust are generally not countable for purposes of determining the beneficiary’s eligibility for government benefits and college financial aid.  Assets held in a custodial account for a child are considered owned by the child.  Assets owned by the child can affect their eligibility for government benefits if they became disabled. Additionally, assets owned by a student are highly weighted in the financial aid calculation for colleges and may adversely affect their ability to receive grants and subsidized loans.

4. Funds in a trust a trust are protected from creditors and spouses.  If the minor were sued for any reason, the trust protects the account from creditors.  Assets in a trust are also protected from future spouses in a divorce.

5. Trusts can allow you to designate who receives the funds if the minor dies. This can be particularly important if you are divorced. If your child passes away, the funds would likely end up with your former spouse as the next of kin.

Special Rules for Trusts in the Context of Retirement Accounts

Leaving retirement accounts to a trust is a highly specialized area of estate planning. If the trust is not structured correctly, it can trigger taxes on the entire balance of the account upon transfer to the trust, destroying any tax deferral and resulting in a higher tax rate on the proceeds. Leaving a retirement account to your estate can have the same effect.

If you have a substantial amount in your retirement account, it’s important to consult with an attorney who specializes in estate planning to determine what type of arrangement is best for your situation.

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About the Author

Shannon McNulty

Shannon McNulty is the founder of Savvy-Parents.com and a lawyer in New York City who provides legal planning for parents with young children. Shannon received her J.D. from Georgetown University Law Center and her LL.M. in Taxation from NYU School of Law. She has also earned her CERTIFIED FINANCIAL PLANNER(TM) designation. You can learn more about Shannon and her firm at www.cityparentslaw.com.

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