Many people are wary of naming a grandchild as beneficiary of a Roth IRA because that might mean paying an extra 50 percent generation-skipping transfer (GST) tax. However, even if that tax must be paid (which is by no means certain), your family probably will come out ahead by stretching distributions over an extra generation. To make this strategy work, the GST tax should be paid from other, non-IRA funds, which will keep your Roth IRA intact for greater future growth.
Why does it make sense to leave a Roth IRA to a grandchild, even if your family will have to pay GST tax? Because of the power of tax deferral. If your son inherits your IRA when he is 59, for example, he will have 25 years of compounding. But if your son’s daughter inherits, at age 26, she will have 56 years to stretch out distributions: an extra 31 years. Counting distributions and the earnings on those distributions, your family could wind up with two-and-half times as much money, by naming a grandchild. Today’s $500,000 Roth IRA could generate $60 million for your family, tax-free.