How to Leave Grandkids Retirement Savings Without a Huge Tax Bill

Leaving a financial legacy for grandchildren is a common goal. Inherited retirement savings can have significant tax implications. Careful planning is required to maximize benefits for future generations. This article explores approaches to leave retirement savings to grandchildren without a large tax bill.

Understanding Inherited Retirement Accounts for Grandchildren

The landscape of inherited retirement accounts changed with the passage of the SECURE Act in 2019. Prior to this legislation, non-spouse beneficiaries could stretch distributions from inherited Individual Retirement Accounts (IRAs) over their own life expectancy. For deaths occurring on or after January 1, 2020, the SECURE Act introduced a new 10-year distribution rule for most non-eligible designated beneficiaries, including grandchildren. This means the entire balance of the inherited retirement account must be distributed by the end of the tenth calendar year following the original account holder’s death.

Grandchildren fall under the category of “designated beneficiaries” subject to this 10-year rule. An “eligible designated beneficiary” (EDB) can still stretch distributions over their life expectancy, but this category excludes adult grandchildren. EDBs include:
Surviving spouses
Minor children of the original account holder (until they reach age 21)
Disabled individuals
Chronically ill individuals
Non-spouses who are not more than 10 years younger than the decedent.

Since grandchildren are more than 10 years younger than their grandparents and are not minor children of the account holder, the 10-year rule applies to their inheritance.

Distributions from an inherited traditional IRA are taxed as ordinary income to the grandchild. This means the inherited funds are added to their other income for the year and are subject to their marginal income tax rate. Taking a large lump sum distribution or withdrawals in any single year could push the grandchild into a higher tax bracket, increasing their tax liability. However, the 10% early withdrawal penalty for distributions before age 59½ does not apply to inherited IRAs.

In contrast, inherited Roth IRAs offer a tax advantage. Since contributions to a Roth IRA are made with after-tax dollars, qualified distributions from an inherited Roth IRA are tax-free for the beneficiary. This tax-free treatment applies as long as the original Roth account was open for at least five years before the owner’s death. Even with the 10-year distribution rule, Roth withdrawals are tax-free, meaning the grandchild receives the full value.

Strategies for Tax-Efficient Wealth Transfer

Grandparents seeking to minimize the tax burden on their grandchildren’s inheritance have several strategies available. These approaches aim to reduce or eliminate the income tax liability that accompanies inherited traditional retirement accounts. Planning before death can enhance the net value of the legacy received by grandchildren.

One strategy involves converting traditional IRA or 401(k) assets to a Roth IRA during the grandparent’s lifetime. A Roth conversion requires the grandparent to pay income taxes on the converted amount in the year of conversion. This shifts the tax burden from the grandchild to the grandparent, who may be in a lower tax bracket or can manage the conversion over several years to control their taxable income. Once the funds are in a Roth IRA, distributions to the grandchild will be tax-free, bypassing ordinary income tax.

Gifting non-retirement assets or after-tax proceeds from retirement savings is another approach. This can involve directly funding 529 college savings plans or Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts. Contributions to a 529 plan grow tax-free, and withdrawals are tax-exempt if used for qualified education expenses. Grandparents can contribute up to five years’ worth of the annual gift tax exclusion in a single lump sum to a 529 plan, which is $95,000 in 2025.

UTMA/UGMA accounts allow for gifts of cash or securities, with the minor owning the assets. While earnings in these custodial accounts are taxed to the child, the first portion of earnings may be tax-free or taxed at the child’s lower rates, with higher earnings potentially taxed at trust rates.

Life insurance can also transfer wealth tax-efficiently. Grandparents can use retirement savings or other assets to purchase a life insurance policy, naming the grandchild as the beneficiary. The death benefit from a life insurance policy is received by the beneficiary income-tax-free. Permanent policies build tax-deferred cash value, accessible during the grandparent’s lifetime if needed.

Trusts can provide a way to manage distributions to grandchildren, with varying tax implications. A “conduit trust” receives distributions from an IRA and passes them through to beneficiaries. For non-EDBs like grandchildren, the trust would still need to distribute all funds within the 10-year period. An “accumulation trust” allows the trustee to retain distributions within the trust rather than passing them to the beneficiary, offering more control over timing. However, income retained within an accumulation trust is taxed at higher trust tax rates, which can reach the highest marginal rate faster than individual tax rates.

Grandchild’s Tax Management After Inheritance

Once a grandchild inherits a traditional retirement account, managing the 10-year distribution period is key to minimizing income tax. While the entire account balance must be withdrawn by the end of the tenth year following the original owner’s death, the grandchild has flexibility in timing distributions. They can take distributions annually, take larger amounts in some years, or withdraw the entire balance in the tenth year.

Strategic timing of withdrawals can help manage the grandchild’s income tax exposure. For instance, if the grandchild anticipates periods of lower income, perhaps during college or a career transition, taking larger distributions in those years could result in the funds being taxed at a lower marginal rate. Conversely, taking a large lump sum distribution in a single year, especially if the grandchild has other significant income, could push them into a much higher tax bracket, increasing their tax bill. Understanding their current and projected income, as well as the federal income tax brackets, is important.

Distributions from traditional inherited IRAs are reported as ordinary income on the grandchild’s tax return. This means the amount withdrawn is added to their other taxable income. The grandchild will receive a Form 1099-R from the custodian reporting the distribution, and must include this income on their federal income tax return.

If the grandparent utilized strategies like 529 plans or life insurance, the grandchild’s tax obligations or benefits differ. Withdrawals from a 529 plan used for qualified education expenses are tax-free at the federal level, and often at the state level. Life insurance proceeds received by a beneficiary are income-tax-free, providing a tax-efficient inheritance. For UTMA/UGMA accounts, the income generated by the account is taxed to the minor, often at lower rates, but withdrawals are not subject to additional income tax or penalties.

Given these complexities and various wealth transfer strategies, consulting with a qualified tax advisor or financial planner is recommended. These professionals can provide personalized guidance, navigate rules and regulations, and assist in developing a plan tailored to the grandchild’s financial situation and goals. Their expertise can help ensure the inheritance is managed to maximize benefit and minimize tax liabilities.