February 27, 2023
IRAs Paid to Minors- An Observation and a Couple of Traps
Take-Away: Naming a minor as the beneficiary of an inherited retirement account requires a fair amount of thought, either as to the use of a minors account or a Trust for the minor. Moreover, there are rules, and exceptions to rules, under the SECURE Act’s Proposed Regulations that make distribution decisions even more complicated if the goal is to stretch the taxable distributions to the longest period possible.
Background: We all know that with the SECURE Act, starting in 2020, the rules for distributions to a minor beneficiary were radically altered. Out went the old stretch distribution rule, that exploited the beneficiary’s life expectancy when taking distributions from an inherited IRA. In its place was a much more narrow set of distribution rules when a minor is the named beneficiary of the decedent’s IRA. If an IRA owner had died prior to 2020, then the old stretch distribution rules were grandfathered, which meant that distributions to the minor beneficiary could be spread out over the minor-later adult beneficiary’s lifetime.
Practical Observations: If a minor is directly named as the beneficiary of an IRA, then a guardian/conservator will have to be appointed for the minor beneficiary. An alternative, and not as expensive as a Trust, is to establish a custodian account under either a Uniform Gifts to Minors Act or the Uniform Transfers to Minors Act (UTMA.) A UTMA can be named directly as the beneficiary of the decedent’s IRA. Thus, for example, the IRA beneficiary designation form would name- “John Doe, as custodian for Charlie Doe, under the Michigan Uniform Transfer to Minors Act.” Upon the IRA owner’s death, John Doe could set up an inherited IRA account for Charlie under the state’s UTMA, after which John would control and manage the assets until Charlie reaches age 21 under Michigan’s UTMA, when he would then gain control of the inherited IRA account. While a UTMA is inexpensive and fairly straight-forward, usually a Trust is named as the IRA’s designated beneficiary due to the greater flexibility and delay before the minor/now adult gains control of the inherited IRA.
EDB: A minor child of the account owner is one of the five categories of eligible designated beneficiary (EDB.) If the beneficiary of the decedent’s IRA is the minor child of the decedent, the child (or their guardian, conservator, or custodian) can take annual required minimum distributions (RMDs) based on the child’s single life expectancy until age 21 is reached. At that time the 10-year distribution rule applies.
Example: Dan died in 2020. The beneficiary of Dan’s IRA was Sam, age 10. As an eligible designated beneficiary, Sam can stretch distributions from the inherited IRA over his single life expectancy. This will go on for 11 years until Sam’s 21st birthday, in 2031. When Sam has reached the age of majority (age 21 regardless of state law to the contrary), the SECURE Act 10-year distribution rule will then apply. Sam must continue to take required minimum distributions in years 2032 through 2041, the end of the 10th year after he reached age 21.
Example: Dan died in 2020. The beneficiary of Dan’s IRA was a conduit see-through Trust established for the benefit of Dan’s son, Sam, who was age 12 at the time of Dan’s death. Until Sam reaches the age 21, required minimum distributions must be taken annually from the inherited IRA stretched out over Sam’s single life expectancy. Once Sam reaches age 21, the SECURE Act’s 10-year distribution rule applies; by the end of the 10 years, all of the remaining inherited IRA funds will be paid to Sam. Additionally, under the SECURE Act’s Proposed Regulations, required minimum distributions to Sam must continue from the inherited IRA to the conduit see-through Trust, and from the Trust to Sam, for years 1-9 of the 10 year term. Since required minimum distributions had already begun on Sam’s single life, those distributions cannot be stopped during the subsequent 10-year term after Sam reaches age 21.
Minor Beneficiary: Distributions to a minor beneficiary, but the beneficiary is not the minor child of the IRA owner, will be subject to the SECURE Act’s mandatory 10-year distribution period.
Example: Oliver, age 70, dies leaving his IRA to his grandson, Greg, age 10. Since Greg is not the child of Oliver, Greg (or his guardian or custodian) will be subject to the 10-year required distribution period, which means the inherited IRA must be emptied by December 31 of the 10th anniversary of Oliver’s death. But no annual required distributions need be taken until the 10th year.
Example: If Oliver was age 75 at the time of his death, and Greg his grandson was named as the beneficiary of Oliver’s IRA, Greg would have to take annual required minimum distributions from the inherited IRA. (i) Greg was not the child of Oliver; and (ii) Oliver was over his required beginning date (RBD) at the time of his death, so that annual RMDs must be taken from the inherited IRA for years 1-9, with the balance of the IRA emptied with a final distribution to Greg on the 10th anniversary date of Oliver’s death.
Multiple Trust Beneficiaries: The SECURE Act’s Proposed Regulations include a special rule that may be helpful for a Trust that has a minor child of the IRA owner named as a trust beneficiary. As a generalization, there is no separate accounting for a Trust. If there were multiple trust beneficiaries and they are not all eligible designated beneficiaries, the Trust would otherwise be subject to the SECURE Act’s 10-year distribution rule. However, the Proposed Regulations provide that if one of the trust beneficiaries is a minor child of the deceased IRA owner, that minor child qualifies as an eligible designated beneficiary even if the other trust beneficiaries do not meet that definition. Consequently, distributions from the inherited IRA payable to the Trust can be stretched over the minor beneficiary’s life expectancy until age 21. At that time, the SECURE Act 10-year distribution rule would then apply.
Example: Dan dies in 2022. Dan created a see-through Trust for the benefit of his two sons, Steve and Sam. Steve is age 25. Sam is age 18. Sam is considered an eligible designated beneficiary, despite the fact that Steve does not within that statutory definition. Annual required minimum distributions could be taken by the trustee of Dan’s from the inherited IRA until Sam reaches age 21, in 2025. The SECURE Act’s 10-year distribution rule would then apply, and the remainder of the inherited IRA balance would have to be paid to the Trust by 2035.
Accumulation See-Through Trust: Other minor beneficiaries of Trusts who are not a child of the IRA owner will not qualify as eligible designated beneficiaries. Consequently, distributions to a Trust for these minor beneficiaries, e.g. nephews and nieces, will be subject to the 10-year distribution rule. However, the Proposed Regulations provide some relief when it comes to calculating required minimum distributions during the 10-year distribution period for these minor trust beneficiaries. A remainder beneficiary of an accumulation see-through Trust can now be disregarded when the Trust’s terms require a full distribution to a minor child (later adult) beneficiary by the end of the year when that former minor beneficiary attains age 31. The only way the remainder trust beneficiary would be entitled to those funds would be if that prior beneficiary died before age 31.
Example: Oliver, age 75, creates an accumulation see-through Trust and it is named as the beneficiary of Oliver’s IRA. The Trust’s terms require a full distribution of all trust assets when the beneficiary of the Trust, Oliver’s grandson Greg, attains age 31. If Greg dies before the scheduled termination of Oliver’s Trust, then any amounts remaining in the Trust will be paid to Oliver’s brother, Richard. Richard can be disregarded as a trust beneficiary. Oliver’s Trust is subject to the 10-year distribution rule with any distributions calculated using Greg’s life expectancy, not Richard’s.
Conclusion: Obviously some thought, and care, needs to go into naming a minor as the beneficiary of a retirement account. A UTMA account can be use due to its low cost and simplicity, but the fact remains that the former minor will gain access to the retirement funds held in the inherited IRA once age 21 is reached. A see-through Trust is a more likely candidate to be named as the beneficiary of a decedent’s IRA if the amount held in the IRA is substantial. While a minor child of the account owner can gain some benefit by being classified as an eligible designated beneficiary, the maximum allowable stretch in taking distributions is only until that child attains age 31 years. Other minors named as beneficiaries of an inherited IRA simply have 10 years in which to empty the IRA. While these rules are arguably helpful to a degree, they are just more rules that advisors have to remember, always with the 50% excise tax hanging over heads if the wrong rule is applied and there is a failure to take a required minimum distribution.