When you set up your IRA, or other tax-deferred retirement plan, consider including your grandchildren on the list of beneficiaries. However, you have to keep in mind the generation-skipping transfer (GST) tax.

Here are the basic guidelines for designating an IRA beneficiary:

  • If you're married, your spouse is probably your first choice. Later, he or she can roll over the inherited IRA and name new beneficiaries.
  • If you're divorced, widowed or never married, you may name your child or children. After your death, your children can stretch out minimum distributions over their life expectancies.

    The Gist of the GST

        For 2012, the GST tax rate is 35 percent (unchanged from 2011).
        Fortunately, there is a $5.12 million exemption to the GST in 2012 (up from $5 million in 2011).
        Suppose a person dies in 2012, leaving $5.5 million to his or her grandchildren. If so, $5 million would be exempt from GST tax but the other $388,000 would be taxed at 35 percent, and the GST tax would be in addition to the federal gift or estate tax.

 

What's wrong with these two options? Your spouse or your children might not need the money in your IRA. Let's say they are relatively well off. If they inherit your IRA, they'll have to take distributions over a relatively short life expectancy period, which accelerates the payment of income tax. And after paying this tax, the unneeded cash may pile up and become subject to estate tax when the IRA beneficiary dies.

Perhaps it would be better if your grandchildren inherited the money. On the other hand, at this stage of your life, you might not know whether your spouse or children will need your IRA money.

One solution: Consider naming your children as IRA beneficiaries and your grandchildren as contingent beneficiaries. Alternatively, you can name your spouse as IRA beneficiary and use a cascading designation. Your children can be secondary beneficiaries and your grandchildren can be tertiary beneficiaries.

However, don't name minors as any type of beneficiary. Instead, it's best to name a trust, with the minors as trust beneficiaries. 

In any case, after your death, the primary beneficiary will have until September 30 of the year after you die to decide whether to disclaim the IRA to the contingent beneficiary. And with a cascading designation, the contingent beneficiary can disclaim in favor of a tertiary beneficiary. 

With this plan, the payoff may be greater wealth in the long run for your loved ones.

 

For example: Let's say your son inherits your IRA when he is 60 years old. Under the current IRS life expectancy tables, he has a 25-year life expectancy, so he must withdraw at least 4 percent (or 1/25th) of the IRA in the first year. After 25 years, nothing will be left.

If your son disclaims in favor of his 23-year-old daughter, she will have a 60-year life expectancy. That means she must only withdraw 1.67 percent of the IRA the first year. She'll enjoy an extra 35 years of tax-deferred compounding. Depending on the investment results of your IRA over those 35 years, the total cash flow to your granddaughter could be enormous.

Some IRA owners shy away from this strategy because leaving an IRA to grandchildren -- either outright or in trust -- may trigger the generation-skipping transfer tax. If a grandparent-to-grandchild IRA bequest is subject to estate tax and GST tax, the total tax may be as much as 75 percent of the IRA's value.

Fortunately, leaving an IRA to your grandchild can still make sense, because you have a $5.12 million GST exemption in 2012.

Consult with your estate-planning adviser about the best way to set up IRA beneficiaries to ensure that the maximum amount of money goes to your loved ones.

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