If your estate plan includes passing down traditional IRAs to children and grandchildren, you better make an appointment with your estate planning attorney soon. Changes that began with the 2017 Tax Cuts and Jobs Act may turn your planning inside out. Your children might find themselves in the top tax bracket, which is not likely what you had in mind.
The Tax Cuts and Jobs Act brought about a big change in how children are taxed on unearned income. This includes required minimum distributions (RMDs) from inherited IRAs.
The change means that tax rates on these required distributions now could be much higher, says Kiplinger in the recent article “Beware of Kiddie Taxes When You Leave Heirs Your IRA.”
This is called a “kiddie tax.” It is levied on a child's investment income above an exemption amount ($2,100 in 2018 and $2,200 in 2019).
Before the new tax law, the tax rate used for a child’s unearned income was the same as the parents' income tax rate.
However, under the TCJA, the parent’s tax rates no longer apply. Instead, the tax imposed on unearned income for children is the same as the rates that are applied to trusts and estates. This will remain in effect through 2025.
Like the trust and estate tax rate, the kiddie tax rate jumps to the highest tax bracket of 37%, with just $12,751 in unearned income in 2019. In contrast, the 37% tax rate doesn’t begin, for example, for a married couple filing a joint return, until their taxable income gets to $612,351.
Unearned income that’s subject to the kiddie tax includes interest and dividends from investment accounts, capital gains, Social Security survivor benefits, rents, royalties, pension income and income from inherited traditional IRAs. The tax applies to unearned income of children under age 19 or, if full-time students, under age 24.
Because IRA distributions are unearned income for kiddie tax rules, required distributions to children—especially from larger inherited traditional IRAs—can be subject to very high tax rates very quickly, even when the parents pay lower rates.
The negative impact of the kiddie tax will apply primarily to large IRAs, if there are no other sources of unearned income, since RMDs will be under 1.67% annually in the early years of distributions.
More changes may be coming in the near future, depending on the final version of the Secure Act, which includes new requirements for non-spouse IRA distributions. In the meantime, consider converting the traditional IRA to a Roth IRA, when the beneficiary is a young child or a grandchild. Your estate planning attorney will know the best tax planning strategy for you and your heirs.
Reference: Kiplinger (July 17, 2019) “Beware of Kiddie Taxes When You Leave Heirs Your IRA”