Making Gifts to Kids

Many of my clients ask questions about how to make gifts to grandchildren, either during life or after death. There are lots of ways to do this, and a few ways NOT to do it, too. Here's the main thing to avoid: naming minor children directly as beneficiaries of retirement accounts, annuities, life insurance, or payable on death accounts. Naming a minor child directly means that unless the gift is worth less than $5,000, a property guardian must be appointed by a court before that asset can be transferred to the child. A property guardian is responsible for managing that asset until a child turns 18, and can also come with restrictive financial options and the requirement of annual reporting to the court. For both of these reasons, and also because it terminates at age 18, a property guardianship is the least desirable way to leave money to young children. Here are some better ways to do it:

If you want to name a child as a beneficiary for an annuity or any account with a beneficiary designation, don't name that child directly. Instead, name that child's parent, as custodian for that child to age 21 (or 25), under the California Uniform Transfers to Minors Act: "Jane Doe, as custodian for Michelle Doe, to age 25, under the California Uniform Transfers to Minors Act." If you name a custodian for the minor, no property guardian needs to be appointed by the court. You can choose any age between 18 and 21 for the custodianship to terminate for gifts made during your lifetime and up to 25 for gifts made at death, but you can't go past age 25 under California law.

You can also leave money to minor children in a Will or a trust in this way, avoiding any need for a property guardian or the establishment of a trust. The custodian can accept the money on behalf of the minor and open up a custodial account at a bank or brokerage company.

Many people know about the $14,000 annual gift tax exclusion, which allows you to give each grandchild an annual gift of $14,000 free of gift tax. These annual gifts don't need to be reported on a gift tax return and do not use up any of your lifetime gift and estate tax exemption, which is currently $5.45 million per person. But fewer people know about the "ed-med" exclusion, which says that direct payments to medical providers and educational institutions for tuition are also free of gift tax, as long as these payments are made directly to the provider or the school, and not given to a grandchild first. Tuition can be paid for primary, secondary, preparatory school, as well as colleges and universities.

If you would like to leave money for a grandchild to be used for college or graduate school, making a contribution to an existing 529 College Savings Account, or opening one up for a grandchild, is a great way to do this. A 529 plan, named for the section of tax code that governs it, is a plan operated by a state or educational institution and provides tax advantages and incentives to make it easier for families to save for college. Contributions to 529 plans are not tax-deductible, but earnings from these plans are not subject to federal tax when the money is withdrawn as long as it is used for qualified education-related expenses, such as tuition, fees, books, and room and board. That means that the money grows on a tax-free basis and is not taxed upon withdrawal either. Even better, if the child doesn't use up the entire account, the money can be used for other related family members (such as siblings) for their qualified educational expenses as well. Each state has one 529 Plan available (most run by large financial institutions), but there's no requirement that you participate in your state's plan. Some states provide a tax incentive for state residents to use their in-state plan, but California is not one of those states. To compare investment options, Saving for College.com does a great job of comparing these plans.

Custodial accounts must terminate by age 21 or 25. College savings plans are for college expenses. But what if you want to provide money for a wider set of uses, such as buying a house, traveling, or getting married? And what if you want to make sure that the money you are giving to your grandchildren is managed for them by an adult until your grandchildren are thirty or forty years old? For more flexibility, you will need to create trusts for grandchildren. A custom-drafted trust can be tailored for your specific objectives and can last as long as you want it to last. Such trusts can be part of your own estate plan, distributing assets to grandchildren upon your death, or they can be created as irrevocable gift trusts during your lifetime, and funded with gifts of cash or others assets, financed through the purchase of life insurance, funded with gift tax-free annual gifts, or even created by making a charitable gift and naming a grandchild as the income beneficiary during that trust's terms.

Most people know they can put money annually into a Roth IRA, but few are aware that a Roth IRA is also available to minors. In fact, both traditional IRAs and Roth IRAs are available to children, as long as they have a paying job. Contributing to a child's retirement account can be an amazing gift because money invested early will have many years to grow tax-free before it needs to be withdrawn and because young adults are often not able to make retirement contributions when such contributions can be most beneficial (early) since that's also when they are starting both their careers and their families. If your grandchild is working weekends and summers and has income, a gift to them equal to their wages up to their annual contribution limit can be put into a Roth IRA in their name. That amount will grow and compound, tax-free, for decades.

Contributions to a traditional IRA are tax-deductible, but earnings are subject to tax upon liquidation of the account. Contributions to a Roth IRA aren’t tax-deductible, but earnings aren’t subject to tax upon liquidation. The Roth IRA is clearly the better choice for most children. Since children typically don’t earn enough to pay income tax, they don’t benefit from the tax-deductible contributions to a traditional IRA. But they will benefit enormously from not having to pay tax on earnings when they liquidate their Roth IRA after they reach the age of 59.5.

Any gifts to grandchildren are also potentially subject to the Generation Skipping Transfer Tax (GST). This is a tax that is equal to the maximum estate tax rate (40%) and falls on gifts that are made to anyone one or more generations below the donor. There is a GST exemption equal to the federal estate tax exemption, currently $5.45 million per person, so most gifts made to grandchildren will be exempt for most people. However, the very wealthy need to work with an experienced estate planner before making any large gifts, either outright or in trust, to maximize the use of their GST exemptions and to avoid any inadvertent triggering of such a tax.

If you or anyone you know is interested in making gifts to grandchildren, feel free to get in touch or share this article with them.