Child, Grandchild, or Other Individual as Beneficiary of Traditional IRA or Retirement Plan
What is it?
Naming a beneficiary for your traditional IRA or employer-sponsored retirement plan may be one of the most important financial decisions you ever make. The beneficiary (or beneficiaries) you name will receive the funds remaining in your IRA or plan after you die, so consider your loved ones' future needs. However, choosing the right beneficiary is often more complicated than that. Your choice could have an impact in one or more of the following areas:
- The size of the annual required minimum distributions (RMDs) that you must take from the IRA or plan during your lifetime
- The rate at which the funds must be distributed from the IRA or plan after your death
- The combined federal estate tax liability of you and your spouse (assuming you are married and expect estate tax to be an issue for one or both of you)
If you are married, your first thought may be to name your spouse as the primary beneficiary of your IRA or plan. Naming a spouse is very common because it often makes sense for several reasons . If you are not married, though, you will have to consider other possible beneficiary choices. (Even if you are married, naming someone other than your spouse may sometimes be a better beneficiary choice.) Children, grandchildren, other relatives, and close friends are popular beneficiary choices for IRA owners and plan participants. You must look closely at your situation and seek professional advice to make the right choice.
This discussion applies only to traditional IRAs and employer-sponsored retirement plans. Choosing a beneficiary for a Roth IRA involves different considerations.
Federal law may require that you designate your spouse as the primary beneficiary of your 401(k) or other retirement plan account, unless your spouse signs a timely written waiver allowing you to name a different beneficiary. Also, if you live in a community property state, your spouse may have legal rights in your IRA regardless of whether they are named as the primary beneficiary.
In the case of minor beneficiaries (e.g., young children and grandchildren), it may be in your best interest to establish a custodial account or a special trust to receive the IRA or plan distributions on behalf of the minor. Consult a tax professional for details.
The information that follows is based on rules that took effect after passage of the original SECURE Act in 2019 and applies to situations in which the original account owner dies in 2020 and beyond. For information on the rules governing deaths prior to 2020, consult a tax advisor.
Your beneficiary choice usually does not affect required minimum distributions during your life
Under federal law, you must begin taking annual RMDs from your traditional IRA and most employer-sponsored retirement plans [including 401(k)s, 403(b)s, 457(b)s, SEPs, and SIMPLE plans] by April 1 of the calendar year following the calendar year in which you reach age 73 (age 75 if you reach age 73 after 2032) — your "required beginning date." With employer-sponsored retirement plans, you can delay your first distribution from your current employer's plan until April 1 of the calendar year following the calendar year in which you retire if (1) you retire after age 73 (age 75 if you reach age 73 after 2032), (2) you are still participating in the employer's plan, and (3) you own 5% or less of the employer. Your choice of beneficiary generally will not affect the calculation of your RMDs unless your spouse is your sole designated beneficiary for the entire distribution year and they are more than 10 years younger than you.
Your beneficiary choice will affect RMDs after your death
Different RMD rules apply to beneficiaries. The timing and amount of RMDs on inherited accounts depend on whether the beneficiary is:
- a spouse who is the sole beneficiary
- an eligible designated beneficiary (EDB)
- an individual who is not an EDB
- not an individual (e.g., an estate or charity)
The RMD rules also depend on whether the owner dies before, on, or after the RBD.
A beneficiary can always take more than required amount in any year, but not less.
Different rules apply after your death if you have not named a beneficiary.
Spouse as sole beneficiary
Spouses who are sole beneficiaries have preferential treatment. If the account owner dies before the RBD, the spouse may wait until December 31 of the year in which the deceased would have had to begin RMDs to take a distribution. Alternatively, regardless of when the account owner died, a spouse can roll over account assets to their own retirement accounts or they may elect to treat a deceased account owner's IRA or retirement plan as their own. By assuming ownership of the original account, the surviving spouse can make additional contributions (IRAs only), name new beneficiaries, and wait until their own RBD to start taking distributions.
Eligible designated beneficiaries
EDBs are spouses and minor children of the account owner, beneficiaries who are not more than 10 years younger than the account owner (such as a close-in-age sibling), and those who meet the IRS's definition of disabled or chronically ill.
If the account owner dies on or after the RBD: an EDB must calculate distributions using their life expectancy or the remaining life expectancy of the account owner, whichever period is longer.
If the account owner dies before the RBD: the EDB would use their life expectancy to determine the RMDs.
In these cases, RMDs must begin no later than December 31 of the year after the original account owner's death.
Note that if the original owner was of RMD age and failed to take the required amount in the year of death, the beneficiary must take the account owner's distribution by December 31 of that year. In subsequent years, the beneficiary can use their life expectancy.
The entire account must be distributed 10 years after a minor child EDB reaches age 21 or after the death of an EDB.
Other designated beneficiaries (individuals)
Designated beneficiaries who are not EDBs (such as grandchildren and children who are not minors) are required to liquidate inherited accounts by December 31 of the year of the 10th anniversary of the account owner's death. In early 2022, the IRS issued proposed regulations stipulating how the accounts should be liquidated based on when the account owner died. Following are those proposed rules:
If the account owner dies on or after the RBD: the beneficiary is generally required to take RMDs based on their life expectancy in years one through nine, and then liquidate the remaining assets in year 10.
If the account owner dies before the RBD: the beneficiary is not required to take annual RMDs but must still liquidate the account by year 10. In this case, the beneficiary might want to spread the distributions over the 10 years in order to manage the annual tax liability.
As of early 2024, the IRS had yet to issue final regulations; however, it has issued notices stating that certain beneficiaries who did not adhere to the annual RMD requirements under the 10-year rule for 2021, 2022, 2023, and 2024 won't be subject to any penalties.
Regardless of where the final regulations land, this 10-year distribution period could result in unanticipated and potentially large tax bills.
Initially, it may appear as though an EDB has an advantage over a DB due to the ability to spread distributions over a life expectancy. However, consider that a DB who inherits assets before the account owner dies is not required to take distributions until 10 years after the death of the account owner, whereas an EDB is required to begin RMDs no later than December 31 of the year following the year of death.
Under the proposed regulations, an employer-sponsored retirement plan may be able to require EDBs use the 10-year rule and EDBs may be able to elect the 10-year rule instead of using the life expectancy method.
Advantages of naming a child, grandchild, or other individual
The funds may be taxed at a lower income tax rate after your death
When you take a distribution from your traditional IRA or retirement plan, you generally have to pay federal (and probably state) income tax on all or a portion of it. For federal income tax, distributions are taxed at a certain rate according to your income tax bracket, which depends on your taxable income for the year. After you die, the distributions that your beneficiary must take from the IRA or plan will be taxed according to their income tax bracket. Choosing a beneficiary who is in a lower income tax bracket than you can reduce taxation of the IRA or plan funds after your death. This may be true especially for EDBs, but also for other beneficiaries during at least the first nine years of distributions. This is one reason that many people name children, grandchildren, and other nonspousal individuals as beneficiaries.
But it may be many years before your beneficiary has to take post-death distributions from your IRA or plan, and their tax situation could be drastically different by then. For example, a college student who does not work is probably in a low income tax bracket now, but may be in a much higher bracket five or 10 years after graduation. The point is, it can be risky to base your beneficiary choice solely on someone's current income tax bracket.
If you have ever made nondeductible contributions to your traditional IRA or after-tax contributions to your retirement plan, those contribution amounts will be free from income tax when distributed to you or your beneficiary.
Unearned income of children may be subject to the kiddie tax, which makes such income taxable at the parents' tax rates.
Post-death distributions can sometimes be taken over more years
EDBs are generally able to take required post-death distributions over relatively long periods of time — depending on the circumstances, the longer of the account owner's remaining life expectancy or their own. The younger an individual is, the longer their life expectancy, according to the IRS tables. This means that choosing a young EDB (a disabled grandchild, for example) could increase the payout period for post-death distributions. There are two important reasons why a longer payout period can be advantageous.
- It maximizes the growth potential of the funds. The longer funds remain in an IRA or plan, the longer the investment earnings can compound tax deferred. Depending on the size of the account and investment performance, just a few more years of tax-deferred growth could produce thousands of dollars of additional earnings.
- It spreads out your beneficiary's income tax liability on the funds. Your beneficiary is able to pay less income tax each year, since the annual minimum required distribution amounts are smaller. With a short payout period, the larger distributions increase your beneficiary's taxable income each year, possibly even pushing him or her into a higher income tax bracket.
For employer-sponsored retirement plans, consult your plan administrator about the distribution options available.
It may minimize estate tax
When you die, the funds remaining in your IRA or plan will be included in your taxable estate to determine if federal estate tax is due. This is generally a concern if the value of your taxable estate exceeds the federal applicable exclusion amount ($13,610,000 in 2024). However, even if your taxable estate exceeds this amount, the unlimited marital deduction allows you to pass unlimited assets to your surviving spouse free from estate tax at your death. This may seem like a compelling reason to name your spouse as beneficiary of your IRA or plan, but there is more to the story.
Your state may also impose an estate or death tax, with a much lower exclusion threshold than the federal estate tax exclusion.
If you have a large estate that you leave entirely to your spouse, the combined federal estate tax liability of you and your spouse may be higher than necessary. The reason? Leaving everything outright to your spouse may waste your applicable exclusion amount. If you leave a portion of your assets to someone other than your spouse (or in a credit shelter trust for your spouse), you can take advantage of your applicable exclusion amount. The remainder of your estate can be left to your spouse, sheltered by the unlimited marital deduction. When your spouse dies, your spouse's applicable exclusion amount will shelter at least a portion of their taxable estate. By utilizing both spouses' applicable exclusion amounts, this strategy can minimize your combined estate tax liability. IRA or plan funds can be used for this purpose if you name a nonspouse as beneficiary.
Portability of the applicable exclusion amount between spouses may reduce the concern over wasting your applicable exclusion amount when you leave assets to your spouse. Speak with a tax advisor to learn more about portability.
Estate planning for retirement assets is a highly technical area. The right approach depends on your financial and personal circumstances. Be sure to consult a tax professional.
You will be providing for your loved ones
You want to make certain that all of your relatives and loved ones will be financially secure after your death. Depending on your situation, providing for everyone's needs can become a challenge when questions arise as to who should receive which assets. With IRA and retirement plan benefits, it is common to designate your spouse as primary beneficiary (assuming you are married) and children or grandchildren as secondary beneficiaries. Your surviving spouse may be able to roll over the inherited IRA or plan into their own traditional IRA (see below), and designate your children or grandchildren as primary beneficiaries of the new IRA. When your spouse dies, the children or grandchildren will receive the funds remaining in the IRA.
But this strategy may carry a risk. Once your surviving spouse rolls over the inherited funds, they may be free to choose any beneficiaries for the new IRA (and can typically change beneficiaries right up until death). You may implicitly trust that your spouse will follow your wishes, especially if the two of you have discussed and planned for the future. But circumstances may change after your death, and there is often no legal obligation for your spouse to name (or keep) your children or grandchildren as beneficiaries. The risk is especially great if your surviving spouse remarries and names the new spouse as the primary beneficiary. One way to avoid such an outcome might be to name your children or grandchildren as primary beneficiaries, and use other assets to provide for your spouse.
If you have multiple heirs to provide for and are concerned that your desired results may not be achieved after your death, you should seek professional advice from an estate planning attorney.
Disadvantages of naming a child, grandchild, or other individual
Managing Money and Income Taxes
If you want to retain control over your IRA or plan funds after your death, naming a child or other individual as beneficiary may not be the best choice. Beneficiaries who are not EDBs could face the daunting prospect of managing a windfall inheritance, either over a period of 10 years or all at once (in year 10), as well as the resulting tax obligation. Moreover, your beneficiary might take larger distributions than required, or even take a one-time distribution of the entire amount. Such decisions may have adverse tax consequences for your beneficiary, especially if the money is all spent before paying the tax bill. Large distributions will also deplete the funds more rapidly, leaving your beneficiary with less money for the future. Finally, the distributed funds will miss out on further income tax-deferred growth opportunities.
These risks are greater with immature beneficiaries, who may be more likely to squander the inherited funds. However, you can often minimize the risk and retain some control after your death by setting up a trust for the benefit of your intended beneficiaries. You then designate the trust itself as primary beneficiary of your IRA or plan, allowing your chosen trustee to manage the funds after your death. The drawback is that trusts tend to be costly and complicated to set up. For more information, consult an estate planning attorney.
Although a minor child is an EDB, the entire account must be distributed 10 years after the child reaches age 21.
Naming a grandchild or other young beneficiary may raise additional death tax issues
If you expect to have a large estate when you die, naming your grandchild (or other individual two or more generations younger than you) as beneficiary of your IRA or retirement plan may raise additional death tax issues. This is because federal law currently imposes an extra "generation-skipping transfer tax" on transfers of assets in excess of the federal estate tax exclusion amount to an individual who is two or more generations younger than you. For more information, consult an estate planning attorney.
The kiddie tax may apply to a young beneficiary
Children subject to the kiddie tax are generally taxed at the parents' tax rates on any unearned income over $2,600 (in 2024). The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income does not exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support.
