Q. I was thinking about naming my minor grandchildren as beneficiaries of my IRA, to inherit in the event of my demise. But I heard something about the “Kiddie Tax” that might apply here. Can you share any thoughts about this?

A. Yes, the so-called “Kiddie Tax” is essentially a special tax that was adopted years ago to limit the ability of parents or grandparents to shift income-generating assets to minor children or grandchildren in order to reduce the family’s overall income tax burden. This rule needs to be considered when leaving IRA’s and other income generating assets to minors, whether they be children or grandchildren.

Here’s the way the Kiddie Tax works: For 2017, the first $1,050 of unearned income to the minor is tax-free, and the next $1,050 is taxed at the child’s own (usually, lower) tax rate.  But here’s the catch: 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 youngsters:  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 age 19 to 23 and full-time students.

Grandparents may be tempted to leave an IRA to a grandchild because children have a low tax rate, but the “kiddie tax” could make doing this less beneficial. Before doing so, the grandparent should run the numbers and determine whether the income generated by the IRA, as well as any other unearned investment income of the child, will likely put the youngster over the exemption of $2,100 (for 2017), and thereby — at least partially — defeat the income-shifting plan.  While an IRA can be a great gift, consider the following:

On the “plus” side: A young person who inherits an IRA has to take Required Minimum Distributions (“RMD’s”), but because the distributions are based on the beneficiary’s longer life expectancy, the grandchild’s RMD’s each year from the IRA will likely be small and thus allow the bulk of the IRA to continue to grow, tax deferred, over a longer period. So, if the RMD’s to go to the grand child, combined with any other investment income, would be less than $2,100 per year (2017), naming a grandchild as your beneficiary might be a good plan.

On the “minus” side:  If the grandchild’s unearned income is expected to be greater than $2,100 per year (in 2017), the excess will be taxed at the child’s parent’s rate, which would usually be much higher and could be as high as 35%.  Note:  In addition to income from IRAs, the kiddie tax applies to other investments that generate unearned income to the youngster, such as from cash, stocks, bonds, mutual funds, and real estate.

If grandparents wish to leave investments to their grandchildren, they might be better off leaving investments that appreciate in value, but don’t generate income until the investment is sold. As an alternative, Grandparents could leave grandchildren a Roth IRA, because the distributions are tax-free.

My suggestion is that you meet with your tax advisor and evaluate whether your proposed gift makes sense for you. In the right situation, an IRA can be a great gift to a grandchild.

References: “IRS “Publication 929 (2016), Tax Rules for Children and Dependents”; Wikipedia Article; Internal Revenue Code § 1(g); IRS:  “Topic 553:  Tax on a Child’s Investment and Other Unearned Income (Kiddie Tax)”