If a grandparent leaves a traditional IRA to a grandchild, the grandchild must begin taking required minimum distributions within a year after the grandparent dies. These distributions are unearned income that will be taxed at the parent's income tax rate. Grandparents may leave grandchildren a Roth IRA because the distributions are tax-free.
Enacted to prevent parents from lowering their tax burden by shifting investment income to children, this tax law is commonly referred to as the “kiddie tax”. It allows some of a child's investment income to be taxed at the parent's rate rather than the much lower child’s rate.
The kiddie tax applies to individuals under age 18, individuals who are age 18 and have earned income that is less than or equal to half their support for the year, and individuals who are age 19 to 23 and full-time students. In addition to IRAs, the kiddie tax applies to other investments that supply income, such as cash, stocks, bonds, mutual funds, and real estate.
If grandparents want to leave investments to their grandchildren, they are better off choosing investments that appreciate in value, but don't supply income until the investment is sold. For more information on estate planning for IRAs contact Stouffer Legal at 443-470-3599 in the Greater Baltimore area.