Be Aware of the “Kiddie Tax” Before Leaving an IRA to Children

Many grandparents may be tempted to leave an IRA to a grandchild because children have a low tax rate, however, the so-called “kiddie tax” could actually make doing this less beneficial.

An IRA can be a great gift for a grandchild. A young person who inherits an IRA has will need to take minimum distributions, but because the distributions are based on the beneficiary’s life expectancy, grandchildren’s distributions will usually be small and allow the IRA to continue to grow. In addition, children are taxed at a lower rate than adults—usually 10 percent.

Unfortunately, this lower tax rate does not apply to all unearned income. Enacted to prevent parents from lowering their tax burden by shifting investment (unearned) income to children, the so-called “kiddie tax” allows some of a child’s investment income to be taxed at the parent’s rate. For 2017, the first $1,050 of unearned income is tax-free, and the next $1,050 is taxed at the child’s rate. Any additional income is taxed at the parent’s rate, which could be as high as 35 percent. 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 age 19 to 23 who are full-time students.

If a grandparent leaves an 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 rate if the child receives more than $2,100 of income (in 2017). 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 leaving investments that appreciate in value, but don’t supply income until the investment is sold. Grandparents can also leave grandchildren a Roth IRA because the distributions are tax-free.

For more information about leaving an IRA or other investments to grandchildren, contact the knowledgeable attorneys at Zacharia Brown. You may schedule an appointment by visiting our website at PittsburghElderLaw.com or by calling 724.942.6200.