What Happens When a Minor Inherits an IRA?
Understanding the rules and responsibilities when a minor inherits an IRA can help ensure proper management, tax compliance, and future financial security.
When a minor inherits an Individual Retirement Account (IRA), specific rules and responsibilities apply. Since minors cannot directly manage inherited assets, legal and tax considerations dictate how the account is handled until they reach adulthood. Understanding ownership transfer, distribution rules, and tax implications ensures the inheritance is managed properly.
Ownership Transfer to a Minor
A minor cannot legally own an IRA, so a custodian or guardian must manage the account until they reach adulthood. This is typically done through a custodial account under the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA), allowing an adult to oversee the assets. If the original account holder named a custodian in the beneficiary designation, the transition is straightforward. Otherwise, a court may need to appoint one, adding legal expenses and delays.
The custodian controls investment decisions and must act in the minor’s best interest. Mismanagement could lead to legal consequences.
Distribution Options
The SECURE Act of 2020 changed distribution rules for most non-spouse beneficiaries, including minors. A minor beneficiary must withdraw the entire balance within ten years of reaching the age of majority, as defined by their state. Until then, they must take required minimum distributions (RMDs) based on the IRS’s Single Life Expectancy Table. These withdrawals start small and increase over time.
Once the minor reaches adulthood, the ten-year rule begins, requiring the account to be fully depleted within a decade. They can take periodic withdrawals or a lump sum. If the beneficiary is disabled or chronically ill, they may qualify as an eligible designated beneficiary (EDB) and stretch distributions over their lifetime.
Tax Considerations
The tax treatment of an inherited IRA depends on whether it is a traditional or Roth IRA. Traditional IRA withdrawals are taxed as ordinary income, potentially pushing the minor into a higher tax bracket. Spreading distributions over multiple years can help minimize taxes.
Roth IRA withdrawals are tax-free if they meet IRS requirements. If a withdrawal occurs before the five-year rule is met, only the earnings portion is taxed, while contributions remain tax-free.
Inherited IRA withdrawals also affect financial aid eligibility. The Free Application for Federal Student Aid (FAFSA) considers them as income, potentially reducing need-based aid. Since FAFSA looks at income from two years prior, large withdrawals could impact multiple academic years. Spacing out distributions or delaying them until after college can help mitigate this issue.
Custodial Responsibilities
Managing an inherited IRA for a minor requires strict record-keeping for tax reporting and compliance. The custodian must track all transactions, including contributions, withdrawals, and investment changes, to prevent IRS issues or disputes.
Investment decisions should balance risk and growth while ensuring liquidity for required withdrawals. A growth-oriented strategy may be appropriate for the minor’s long investment horizon, but maintaining some conservative investments ensures funds are available when needed. Diversification and periodic rebalancing help manage risk while maximizing returns.
Access Upon Reaching Legal Age
When the minor reaches adulthood—typically 18 or 21, depending on state law—they gain full control over the inherited IRA. The custodial arrangement ends, and they must decide how to manage the remaining funds.
If subject to the ten-year rule, they must withdraw all funds within a decade. They can take annual withdrawals to manage tax liability or withdraw a lump sum if immediate access is needed. Strategic planning at this stage can help minimize taxes while preserving as much of the inheritance as possible for long-term financial goals.