Tax-Savvy Strategies for Passing Wealth to Grandchildren

September 28, 2023

With the implementation of the Secure Act’s new rules for inherited retirement distributions, older Americans are facing the challenge of finding ways to pass assets on to their grandchildren without a large tax bill attached. This law, which took effect in 2020, stipulates that non-spousal heirs have ten years to draw down inherited retirement accounts. If these beneficiaries are minors at the time of inheritance, they have ten years from the age of 18 to complete these withdrawals, meaning that all distributions must be taken by the time they reach the age of 28. Therefore, while the assets in retirement accounts were contributed tax free, the distributions are subject to taxation.

To address these changes, many grandparents are revising their estate plans to establish new trusts designed to safeguard post-tax wealth. Additionally, some are taking immediate actions such as making Roth conversions or significant generation-skipping lifetime gifts to better manage these new regulations.

Roth IRA Conversions

As of spring 2023, American IRA accounts collectively held a staggering $12.5 trillion. Notably, 52% of households are led by individuals aged 65 or older. A significant trend among these older individuals is the adoption of Roth IRA conversions, aimed at ensuring that their descendants, including children and grandchildren, can inherit their wealth tax-free, thereby avoiding income tax obligations at the time of required distributions.

Traditional IRA distributions can pose significant tax challenges for children. Notable challenges arise if the adult child must take those distributions at a time when they are at their highest tax rate. Another concern might be that a minor child would need to pay the income tax at his or her parent’s high tax rate. To address this issue, some grandparents are opting to transfer traditional IRA assets to Roth IRAs where the assets can grow tax free and the distributions will be tax free. In this scenario, the grandparent doing the conversion will pay income tax at the time of the transfer themselves instead.

Lifetime Gifts

Many grandparents make lifetime gifts to their grandchildren and also plan for distributions at their death. For example, grandparents pay for diapers, preschool, 529 contributions, direct tuition payments, etc. These gifts typically do not count as “gifts” for estate tax purposes. Inherited can introduce complex administrative challenges. Once inherited, these IRAs cannot be converted into Roth IRAs. To ensure proper management, custodian parent accounts must be established for minors inheriting IRAs. Without a trust, the IRA distributions could all be taken at once with a big income tax bill. This situation can be particularly challenging for children who may lack the financial knowledge and experience to manage a sudden influx of assets like this.

Trusts can also be used to distribute the inherited IRA distributions. Again, the ten year rule must be followed, but along with other asset distributions, the grandparents or parents can put various requirements such as age, education, business, health, welfare, etc., which the Trustee must follow to make distributions to beneficiaries. Despite the potential complexities associated with leaving an IRA to a trust, it could be a prudent choice to prevent an 18-year-old from quickly depleting the funds at a young age.

Given the above considerations, individuals may want to discuss all their options with a trusted advisor when filing out IRA beneficiary forms.

KJK’s Estate, Wealth & Succession Planning partner Susan Friedman (SLF@kjk.com; 216.736.7272) is well-equipped to guide clients through various estate planning options, including considerations related to IRAs and trusts. This ensures that individuals have a comprehensive understanding of their choices when it comes to safeguarding their assets and providing for future generations.