As a Self Directed IRA account holder gets older, their choice of beneficiaries can change. A common occurrence is when the original beneficiaries – the account holder’s children – have grown and become financially independent. At that point the account holder may wish to designate grandchildren as the beneficiaries in order to help insure their financial future. Other times it may just be personal family dynamics which indicate a minor as being the most favored recipient of a Self Directed IRA. In any case, is it even possible to leave a Self Directed IRA to a minor? And, if so, what is the best way to do it?
Can a minor legally be left a Self Directed IRA?
Yes, with one important caveat. The Uniform Transfers to Minors Act (UTMA) allows minors to accept gifts and not worry about tax implications until they come of age. Legal age is state specific and ranges from 18-21 years old. However, the minor is not allowed access to the account while they are still a minor. A guardian or conservator must be appointed to manage the account until the recipient reaches legal age. There is no way around this as IRS regulations prohibit IRA custodians from dealing directly with minors.
In the case of leaving a Self Directed IRA, the original account owner should be proactive and designate a guardian. (In most cases, this will be one of the minor’s parents.) If a guardian is not designated, the court would have to appoint one and the person chosen may not always act in the minor’s best interest.
The 10-Year Rule
A very pertinent law was passed in the SECURE (Setting Every Community Up for Retirement Enhancement) Act in 2019. It is known as the “10-year rule” and it affects how an inherited IRA can be distributed. This rule states that an inherited IRA (including a Self Directed IRA) must be fully distributed within ten years of receiving it. Prior to the SECURE Act, inherited IRAs were known as “Stretch IRAs” as the RMDs could be stretched over the expected lifespan of the recipient. Now, with the 10-year rule in place, the recipient has 10 years to distribute the entire account. That being said, there are no rules on what form the distribution must take. It can be an orderly distribution spaced out over the 10-year period or it can be distributed all at once on the last day.
One of the exceptions to the 10-year rule is when the Self Directed IRA is inherited by a minor child. (Here “child” is being used in the sense of progeny, i.e. the son or daughter of the Self Directed IRA account holder.) A minor child is designated by the SECURE Act as an EDB – Eligible Designated Beneficiary. This means that the minor child is not bound by the 10-year rule, but rather can take RMDs according to their own life expectancy. However, this status changes once they reach the legal age of maturity. At that point the 10-year rule would kick in and the child would have until December 31 of the tenth year after their 18th birthday to fully distribute the account. The Secure Act does provide one further exception for the minor child and that’s in the case where the child is pursuing a qualified education. In such a case, the child may have until they turn 26 before the 10-year rule would come into effect.
These exemptions only apply to minors who are children; they do not apply to grandchildren or other unrelated minors. In a case where a grandparent leaves a Self Directed IRA to a grandchild, the grandchild would have to fully distribute the account within 10 years, irregardless of their age. Failure to observe the 10-year rule can result in a 50% penalty.
The “Kiddie Tax” and an Inherited Self Directed IRA
The Kiddie Tax is confusing because it has undergone so many iterations. The essence of the tax, however, has remained the same: it is a tax that applies to the unearned income of a minor. The Kiddie Tax law was originally passed in 1986 and it was meant to prevent a tax loophole. Until that time parents would place investments in their children’s name in order to take advantage of the child’s lower tax rate. As a response to this, Congress passed the Kiddie Tax law which made those investments subject to the parents’ tax rate. In 2018 the Kiddie Tax rate was changed under the Tax Cuts and Jobs Act to the rate that applies to estates and trusts. In 2020 the SECURE Act reverted the law and once again applied the parents’ tax rate. Currently, in 2021, this tax rate gets applied to any withdrawals exceeding $2,200.
Let’s take a look at how these rules would apply to a Self Directed IRA being left to a minor.
- Case #1 – Susan leaves a Self Directed IRA to Zack, her 7 year old grandson. In this case, since Zack is not an EDB (like a direct child), he would have to fully distribute the Self Directed IRA within 10 years. The tax rate that would apply to those distributions would be the tax rate of his parents.
- Case #2 – James leaves his 15 year old daughter Lily a Self Directed IRA. Here the rules are a little bit different. Since Lily is the daughter of James, she qualifies as an EDB and has a grace period until she turns legal age (18-21) where she doesn’t have to fully distribute the Self Directed IRA. However, once she does turn legal age, the 10-year rule kicks in. At that point she must distribute the account fully some time over the next ten years. However, here the tax considerations play a big role. If Lily distributes the Self Directed IRA as a minor, the Kiddie Tax would apply, and she would have to pay her parent’s tax rate. If she chooses to wait on distributions until after she is no longer a minor, then the tax rate would be her own. For most people in that age range, their own tax bracket is significantly lower than that of their parents.
To avoid these possible tax implications, there are a number of options that can be considered. The first is a Roth IRA. Since the Roth already has the taxes paid, this won’t be an issue for the minor recipient. If the Self Directed IRA is not currently a Roth, it is a fairly simple procedure to do a Roth conversion. If a conversion does take place, then the recipient would have to wait a 5-year period before being able to take tax-free distributions. Another option is to set up a trust as the beneficiary of the Self Directed IRA and the minor would be listed as the beneficiary of the trust. There are many different kinds of trusts and depending on your family’s situation, a specific kind may be indicated. Ask a financial advisor which trust would make the most sense.
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