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

Grandparents may find it tempting to leave an individual retirement account (IRA) to a grandchild because children have a low tax rate, but the “kiddie tax” could make doing this less beneficial.

IRAs as Gifts for Grandchildren

Before enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019, an IRA was a great gift for a grandchild. A young person who inherited an IRA could take distributions based on their life expectancy. (This meant the grandchild's distributions would be small and allow the IRA to continue to grow.)

The SECURE Act requires that most non-spouse beneficiaries of an IRA withdraw all the money in the IRA within 10 years of the IRA holder’s death. This means that an IRA is not as great a gift to a grandchild as it used to be. Yet children are still taxed at a lower rate than adults — usually 10 percent — making it still worthwhile in many cases.

The lower tax rate does not apply to all unearned income, however.

Remind Me: What Is Unearned Income?

Unearned income, according to the Internal Revenue Service (IRS), includes income based on investments, such as ordinary dividends. It also includes funds you may have inherited, pensions, or unemployment benefits. (In contrast, you have earned income when you receive compensation for your working at your job.)

What Is the Kiddie Tax?

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.

Kiddie Tax: 2024

For 2024, the first $1,300 of unearned income is tax-free, and the next $1,300 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 the following:

• 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 who are aged 19 to 23 and full-time students.

Kiddie Tax Rules

If a grandparent leaves an IRA to a grandchild, under the SECURE Act, the grandchild must take all assets within 10 years of the grandparent's death. (If the grandchild has a disability or is chronically ill, they can take distributions over their lifetime). The 10-year clock does not start until the child reaches the age of majority, either 18 or 21, depending on the state.

The IRA distributions are unearned income that will be taxed at the parent’s rate if the child receives more than $2,600 of income (in 2024).

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.

Also, to ensure that your gift goes to whom you want and is not squandered in ways you may want to avoid, consider making the IRA payable to a trust.

Additional Resources

• Read more about inherited retirement accounts.
• Consult with a qualified attorney in your area to receive further guidance.