Your retirement account may be one of the most valuable things you own. Many consider naming their children as the beneficiaries of these accounts because they think it is a way of efficiently transferring their wealth if something happens to them. However, some factors make this type of transfer more complicated than you may think, especially if your child is a minor.
Yes, you can name your minor child as the beneficiary of your retirement account or the contingent beneficiary who would receive it if the primary beneficiary you named on the account dies before you pass away. However, suppose your child is a minor when you die, and they inherit your retirement account. In that case, a court may have to appoint a guardian or conservator to handle any money distributed to the child from the account. This will take time and money, and the guardian or conservator the court chooses may not be the person you would have chosen. You can avoid this by proactively naming a conservator or guardian for your minor child in your will.
Under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, most beneficiaries must receive an entire retirement account within ten years of the account owner's death. However, minor children of an account owner fall into a particular category of beneficiaries (called eligible designated beneficiaries or EDBs). Their mandatory ten-year payout period does not begin until they turn twenty-one, meaning the beneficiary must receive an entire inherited retirement account at age thirty-one. In the meantime, however, they are required to take required minimum distributions (RMDs), which will likely be held in a protected account overseen by their guardian or conservator until they reach the age of majority in the state they live in (usually between the ages of eighteen and twenty-one). RMDs for these EDBs are based upon the child's expected lifetime, and they must take them until the end of the calendar year that they turn thirty-one, at which time the retirement account must be fully distributed. It is important to note that the child must pay income taxes on any amounts distributed to them. This is usually favorable because the RMDs up until the year they turn thirty-one can be made in smaller amounts because of the long life expectancy of a minor and because they will likely be in a low tax bracket. However, the account must be emptied by the end of the calendar year when the child turns thirty-one. Depending upon the account size, this could mean that the child will receive a large amount of taxable income at a relatively young age. In addition to the potential tax liability, one of the disadvantages of naming a minor child as the beneficiary of your account is that when they reach the age of majority (which could be as young as eighteen in your state), they will gain complete control of the funds and could choose to pull everything out of the retirement account right away, regardless of whether they are mature enough to handle that responsibility.
Another option is to create a trust for your child and to name the trust as the beneficiary of your retirement account. This option can work for see-through trusts that meet specific legal criteria and allow the applicable trust beneficiaries to be treated as the beneficiaries of your retirement account. There are two types of see-through trusts you can consider: conduit trusts and accumulation trusts.
A conduit trust requires all RMDs from the retirement account to the trust to be distributed to the child (or used for the child's benefit) as soon as the trust receives it. The trust will provide asset protection and tax deferral for the funds remaining in the retirement account. In addition, the terms of the trust can ensure that once the child reaches the age of majority in your state, they cannot simply withdraw the entire balance remaining in the retirement account all at once. The trustee can also have the discretion to withdraw funds from the retirement account in addition to the RMDs, which would then be distributed to or for the child's benefit. Still, the trustee will make these decisions about additional withdrawals rather than the child. Although the remaining balance must still be fully distributed to the child by the end of the calendar year in which the child turns thirty-one, until that time, the conduit trust will provide asset protection, tax deferral, and additional time for your child to mature and learn how to handle the money responsibly before receiving a potentially large sum of money.
An accumulation trust, unlike a conduit trust, allows the trustee to decide whether to pay out the RMDs to the child (or for the child's benefit) from the retirement account or to retain the funds in the trust. As a result, the total amount of the funds distributed from the retirement account to the trust can stay in the trust and potentially be protected from claims made by outside creditors. An accumulation trust will enable you to ensure that the funds are not distributed to your child sooner than necessary or desired and that the child does not gain access to the entire amount in your retirement account as young as eighteen. However, the funds must still be fully withdrawn from the retirement account by the end of the calendar year your child turns thirty-one. Any funds retained by the trust instead of distributed to your child will be taxed at the much higher tax rates applicable to trusts rather than the lower rate likely to apply to your child.
Each option has pros and cons, and the one that is best for you and your child will depend on your unique circumstances and goals. We can help you consider whether asset protection, tax minimization, or another goal should be your priority. Suppose you already have made your minor child a beneficiary of your retirement account or have set up a trust as the beneficiary of your retirement plan for the benefit of your children. In that case, reviewing and updating your beneficiary designations and your trust is essential if needed. Some recent changes in the rules that govern these important accounts will significantly impact when the funds must be distributed—and may necessitate a change in your plan. Please call us to schedule an appointment so we can help you think through the best plan for your retirement accounts and any other estate planning concerns.
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Austin, TX 78738
