Last week's article illustrated the amazing potential benefit to future generations of deferring income tax on withdrawals of IRAs of even modest sizes over the life expectancy of very young children. But not so fast. You really shouldn't name baby Jack as the IRA beneficiary. Why? Because Jack, the babe-in-arms, can't make the required withdrawals. He lacks legal capacity. In fact, he won't have legal capacity until he attains the age of 18. The IRS doesn't care; baby or no, the minimum distribution rules still apply. When the minimum required distribution is not withdrawn, a very stiff 50 percent penalty applies.
There are three choices for properly designating a minor beneficiary of your IRA: 1) a legal guardian can be appointed for Jack. (This is expensive and unwieldy — not a good choice.) 2) you can create a trust for the benefit of Jack that meets the IRS requirements for stretching out payments over Jack's, the beneficiary's, life expectancy; 3) you can name a custodian under the Uniform Transfers to Minors Act (UTMA) for the benefit of Jack to receive the IRA on his behalf until he is 21.
A trust specifically to receive the benefit is probably the best choice. It provides the most flexibility and will cover all possible contingencies. This alternative is the most expensive because of the need to create a trust before death, but it gives you the most control over making sure your wishes are carried out.
The most common type of trust used as an IRA beneficiary is a conduit trust. This type of trust requires the trustee to distribute the required distributions each year from the trust to the child so that the child pays the tax rather than the trust, which would generally owe more. The distributions can be made to a UTMA custodian for the minor.
Another type, called an accumulation trust, allows the trustee to stretch out the IRA withdrawals over the child's life expectancy but the trustee could keep all, or part, of those withdrawals in the trust. Withdrawals kept in the trust would be taxed as income at the trust's income tax rate, and any amounts distributed to or for the benefit of the child would be taxed at his or her personal income-tax rate. An accumulation trust has the added benefit of giving you control of deciding when your beneficiaries actually receive money from the IRA withdrawals. There is no requirement that the funds be distributed to the child upon attaining the age of majority.
The third option is a viable, low-cost option of naming a minor as a beneficiary of an IRA. In the beneficiary designation of your IRA account you may designate a custodian, and even a successor custodian, under the Uniform Transfer to Minors Act, for the benefit of Jack (much like should be done in your will for any property passing to a minor). This named custodian receives the minimum required distribution annually, invests it in an account titled "Custodian's Name, Custodian for Jack under PA UTMA" until Jack turns 21. The short-coming of this low-cost option is that Jack inherits both the accumulated funds and the IRA outright when he turns 21.
If the IRA you leave to Jack is a Roth IRA, then you have really hit the ball out of the park. If we assume an 8 percent return, the entire $8.8 million in distributions to Jack will be federal income tax free.
When using any of these techniques, always get written acknowledgment from the plan custodian that they have accepted the beneficiary designation you have made. Keep a copy with your will and other important papers. If your custodian won't cooperate, move your account to a custodian who will. This is much too important to let slide.
E-mail: Patti@spencerlawfirm.com