Retirement Benefits Left to a Minor Child

Take-Away: A minor child named as the beneficiary of their parent’s retirement account is classified as an eligible designated beneficiary under the SECURE Act. The distribution rule is straight forward if the minor is named directly as the beneficiary of their parent’s IRA. More than likely, however, the parent will direct their IRA be paid to a trustee of a trust that is established for the minor child’s benefit. Naming a see-through trust as the IRA beneficiary will work pretty well, but there are some unanswered questions that will have to await answers in the IRS’s promised Regulations.

Basic Distribution Rule: When a minor child of the IRA owner is the sole beneficiary of the IRA, then the ‘old’ life expectancy rule will apply to require very small distributions each year from the IRA until the minor child reaches the age of majority. This is because a minor child of the IRA owner is classified as an eligible designated beneficiary who is able to use the life expectancy distribution rule, but only so long as they are a minor.

• Distribution Percentages: For example, the annual distribution percentage of some young ages are: age 5, 1.29%; age 10 1.37%; age 15 1.47%; age 20 1.59%; age 26 1.75%.
• Distribution After Age of Majority: Once the child becomes emancipated upon reaching the state ordained age of majority, no distributions will need to be taken from the inherited IRA until December 31 of the year 10 years after the child attains the age of majority, due to the SECURE Act’s 10-year distribution rule, which requires no distributions until the 10^th anniversary of the IRA owner’s death or the 10^th anniversary after the child becomes emancipated.
• Age of Majority Ambiguity: It is unclear when a beneficiary will cease to be a minor. The answer to the question is generally governed by state law. 37 states use age 18 years, including Michigan. [Alabama and Nebraska use age 19. Mississippi uses age 21.] In addition, the IRS Regulations state that a child may be treated as ‘not having reached the age of majority if that child has not completed a specified course of education [which, of course, is not defined in the Regulations] until attaining the age 26.’ [Treas. Regulation Section 1.401(a) (9)-6, A-15.] It is not clear from the SECURE Act if the Regulation’s definition of age 26 for students as the ultimate age of majority will control the SECURE Act’s 10-year distribution rule. Thus, it is possible with a lenient interpretation from the IRS, a full-time student who has not completed his/her course of study might have until age 36 years to empty their inherited IRA account.

Conduit See-Through Trust for Minor Child: The life expectancy distribution rule applies if a minor child is the beneficiary of a conduit see-through trust. Therefore, the life expectancy rule can be used by the trustee of the conduit trust until the child reaches the age of majority, at which time the 10-year distribution will then apply, and the entire IRA must be distributed to the trustee, and then to the child-beneficiary, within 10 years of that date of the child’s emancipation.

• “Pot Trust’ Ambiguity: What is not clear is whether there can be a single conduit see-through trust established for multiple children of the IRA owner, i.e. a ‘pot trust’, or whether there will have to be separate IRAs that are payable to separate trusts created for each minor child. An assumption is that if there are multiple minor children trust beneficiaries, like a ‘pot trust’ arrangement, probably the age of the oldest trust beneficiary will be used to trigger the SECURE Act’s 10-year distribution rule, so that when the oldest child-beneficiary reaches the age of majority, the SECURE Act’s 10-year distribution rule will then govern the trustee’s withdrawals from the deceased parent’s inherited IRA. In light of this ambiguity, it is probably safer to have a parent’s IRA beneficiary designation made payable to separate subtrusts which come into existence under the IRA owner’s trust on the owner’s death, so that there is a separate trust for each minor child-beneficiary, and each subtrust will receive its separate share/percent/amount directly from the deceased parent’s IRA, what was and still is called the separate share rule, where the shares are created in the IRA beneficiary designation form.

Accumulation See-Through Trust for Minor Child: If the deceased parent’s IRA is made payable to an accumulation see-through trust for minor children, then the SECURE Act’s 10-year distribution rule will apply.

Parent’s Practical Decision-Making: Income Tax Savings vs Asset Protection?: The parent IRA owner will have to decide whether the income tax deferral gained by leaving the inherited IRA directly to their minor child, or to a conduit trust created for their minor child, is more important than protecting the retirement assets by having the IRA payable to an accumulation see-through trust for their child-beneficiary’s lifetime.  Similarly, there will  need to be a balance between spreading the income tax liability associated with the inherited IRA over a longer period of time, either (i) by naming their minor child as the direct IRA beneficiary with the very low distribution percentages, or (ii) naming a conduit see-through trust for the child as the beneficiary of the parent’s IRA, so those same retirement assets will not have to be fully paid to their child until 10 years after their child is emancipated, and thus subject to the child’s unwise spending, creditors, and possible future divorces.

Trust Drafting Opportunity? Hopefully the IRS’ promised Regulations, when finally published, will also address the ability for the parent to create a trust as their IRA beneficiary that starts as a conduit see-through trust, which permits very small taxable distributions to be made from that trust to their minor child while in his/her youth, only to be later, by the trust instrument’s terms,  convert to an accumulation see-through trust once that child attains the age of majority, in order to protect the ‘lion’s share’ of the IRA assets, albeit distributed from the inherited IRA in the next 10 years, from having to be distributed to the trust beneficiary who may be then legally an adult, but who may likely also need the asset protection afforded by a conventional accumulation see-through trust.

Conclusion: The rule changed drastically for retirement accounts left to children. The stretch IRA is generally gone, to be replaced by the 10-year distribution rule. That change is mitigated to some extent with the start of the 10-year rule delayed until the child attains the age of emancipation, but in the end, a lot of taxable ordinary income will be accelerated in the hands of the child beneficiary. What has not changed are the factors that parents must weigh, either naming the child as the direct beneficiary of their IRA, or alternatively naming a trust for the child as the IRA beneficiary to exploit the advantages of a trustee’s management and control of the IRA.