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Advisor Perspective

Advisor Perspective

Making Gifts to Your Children and Grandchildren

Will Alexander

Advisor, CFP®, J.D.
Will anticipates clients’ complex needs proactively and responds to them quickly, helping them preserve and grow assets with thoughtful, custom solutions. He’s passionate about empowering individuals and families to fulfill their goals and dreams and appreciates the opportunity to share in those experiences.

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Several articles ago, we discussed taking advantage of the annual gift exclusion and possible reasons for making gifts to your children and/or grandchildren during your lifetime (Taking Advantage of the Annual Gifting Exclusion). We also briefly mentioned the accounts one might utilize to fulfill those gifts. As with most things in life and personal finance, the decision on which account to use is complicated and all choices come with benefits and consequences. These factors tend to focus on 3 areas of concern: simplicity vs. complexity, ease vs. difficulty to access the funds by the beneficiary, and lastly the tax and administrative costs.

Minor’s Account (UTMA/UGMA)

In most states minors are not permitted to open accounts at financial institutions solely in their own name and need a guardian involved. These are safeguards put in place to protect children from financial abuse, and they also provide some protection for gifts made by having the oversight of a parent/guardian. Another benefit of these accounts is their simplicity in opening. Often, all that is required is a photo ID for the parent and ID number for the child.

While these accounts are simple at the onset, they may create headaches for the parent or gift-giver. Particularly as the account balance grows larger and larger through either growth or continual contributions. Firstly, these accounts are designed to turn over control to the child at a set age (usually between 18 and 21). While it is beneficial to instill good financial skills at an early age, there comes a point where handing over a large sum to someone college-aged becomes concerning. Secondly and often overlooked, these accounts can have varying levels of tax complexity. Whether invested in securities or simply an interest-bearing savings account, ideally these funds are growing and with that growth comes income. This income may need to be reported on the parents’ tax return or could necessitate the filing of a tax return for the child.

529 Education Account

For many, saving for a child’s or grandchild’s education is their primary concern. While there are a couple different vehicles to accomplish this goal, the most common is the 529 College Savings account. The biggest advantage of these accounts is the tax-free growth when distributions are used for qualified education expenses, which when contributed to early on can have a great impact. They also have several other features that are beneficial. The accounts are typically owned by a parent or grandparent, so access can be controlled. Additionally, the beneficiary of these accounts can be changed to certain relatives. So, if the account ends up overfunded or the child opts not to attend college, then it can be used for a sibling, cousin, etc. Lastly, there may be state income tax benefits for contributions made to these accounts.

While there are many tax benefits for 529 accounts when used for education as intended, there are greater consequences when the distributions are not qualified. To begin, there is a 10% penalty on the earnings. Furthermore, the earnings are also taxed as ordinary income, which would create a greater overall tax liability than if they grew outside the 529 account and incurred the (lower) capital gains rates. Lastly, any state tax benefits received may need to be returned.

A final thought for those in a position to maximize education funding and gifting, payments made directly to the educational institutions do not count as gifts against the annual exclusion or lifetime exemption. Meaning one could pay for college expenses and complete gifts at the same time.

Trust Account

For those who are more concerned about protecting the assets (or protecting the beneficiaries from receiving too much too soon), completing the gifts to a trust may be the better option. Trusts allow the grantor (gift-giver) to put restrictions and guidelines for the use of the trust funds at its creation that are followed through by a trustee. Unlike a UTMA/UGMA, there is no age that would automatically turn over control to the beneficiary and in some states, a trust is allowed to exist in perpetuity for the beneficiary’s descendants. Lastly for income tax purposes, if specified at its creation, a trust can be what is known as an Intentionally Defective Grantor Trust. In simple terms, this allows the trust to be taxed to the grantor of the trust. This avoids the need for a separate tax return to be filed and allows the trust to grow more without the internal cost of tax liability.

As with the other account types, trusts also have some downsides that need to be considered as well. To begin, they are a legal document and as such an attorney should be involved in the drafting, which will have accompanying costs. There may also be ongoing administration. If utilizing an institutional third-party trustee, then there would be associated fees. If utilizing the annual exclusion, then there may be a need to submit a Crummey letter to qualify. This is a letter that provides notice of the gift to the beneficiary and provides a temporary right to make a withdrawal from the trust. Lastly, the trust may be required to file its own tax return. Unfortunately, the higher tax rates kick in for a trust much quicker than for individual filers.

When deciding on gifting, it is important to consider these factors in addition to how much and how often to gift, especially over the long-term. Compounding can transform regular or occasional gifting into tens or hundreds of thousands of dollars as the years go by. Will that create some unintended complexity and costs in the future? Is that too much in your view to put in the hands of a young adult? Is it too much or too little to cover the costs of college? Ultimately, we should think about the intention behind making the gift and choose the path that best aligns with that overall goal.

If you would like to have a conversation about gifting, please call your JMG advisor. The contents of this article may or may not be directly applicable to your situation. In either case, we encourage you to pass this along to someone who may find it helpful.

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