Transferring Your Legacy
Tax-Smart Ways to Share the Wealth with Kids
As parents or grandparents, we want to do what’s best for our children and grandchildren. We want them to enjoy the gifts we’ve given them during our lifetimes—family traditions, connections and values—and we also want our financial legacy to pass to them without complications. But if we don’t manage our gift planning thoughtfully, we could leave future generations with unexpected challenges.
I’ve seen many ways for individuals to transfer wealth from one generation to another, but to my mind, there are just a handful of vehicles that effectively transfer financial gifts for future generations during our lifetimes. Some top considerations are UTMA/UGMA accounts, 529 accounts, IRAs and irrevocable gift trusts.
Which of those options you should choose will depend on the degree of control you wish to retain, the purpose of your gift, and the amount of the planned gift. Let’s review the pros and cons of these various models so that we understand how to work with legal and financial advisers to provide for our heirs.
The simplest method of gifting involves setting up a custodial account under your state's version of the Uniform Transfer to Minors Act or Uniform Gift to Minors Act. These accounts exist for the purpose of allowing gifts to be set aside for minor children who otherwise could not legally own significant property. Custodial accounts allow you to designate someone (including yourself) to manage gifted funds until the child is of age, most commonly 18 or 21.
The upside of this approach is that it takes almost no effort to set up such accounts. The accounts contain standard provisions in accordance with local law, and they are as easy to create as asking your bank to set up a custodial account for you.
Custodial accounts, however, are considered taxable to the child. This could complicate matters if investment income triggers a "kiddie tax," potentially making the child's income taxable at an even higher rate than their parents’ and in line with income tax brackets for non-grantor trusts. As concerning as the federal tax is, keep in mind that your state might have a lower threshold that also could trigger a state “kiddie tax.” Talk with your attorney or tax adviser about these issues before setting up a custodial account.
An even larger downside of custodial accounts is that once the child attains the age of 18 or 21, that account becomes theirs, period. If you plan to make a large gift or a number of gifts, this could mean that a beneficiary as young as 18 wakes up one day with immediate access to a small fortune. How and whether that fortune is managed and used responsibly is entirely up to that child. Is this what you intend?
As much as you might want to undo what you’ve created when you see that child reaching his or her late teens, you may end up opening a legal can of worms. Once funds are transferred into a custodial account, those funds must be used for that child. Even if the child is incapable of managing the assets, the account must still be used for his or her benefit. Failure to adhere to this principle could subject the custodian to a lawsuit on the minor’s behalf alleging that the account was mismanaged.
The bottom line is that custodial accounts should be used only when the total amount gifted is relatively small.
529 plans are an increasingly popular option for passing on wealth to the next generation. The purpose of 529 accounts is for gifted funds to be used for educational expenses, but note that there is a laundry list of expenses that qualify as "educational expenses." It is, therefore, important to familiarize yourself with what a 529 plan distribution can be used for.
The principal benefit of a 529 account is that any income from transfers into the account is free of federal income tax—as long as distributions are used for qualified expenses. Those gains may also be nontaxable under local and state laws, but you should confirm this with your adviser. A 529 account, like a custodial account, allows you to designate who will manage the funds, keeping beneficiaries from having direct control over the money. Unlike with custodial accounts, 529 beneficiaries never have an absolute legal right to receive the funds.
Even better from a tax perspective, contributions to a 529 account still qualify for the annual gift tax exclusion, but they provide additional gift-and-estate-tax planning opportunities, such as allowing you to make front-loaded gifts for up to five years without using your lifetime estate tax exemption, sometimes referred to as “superfunding.”
Another important benefit of a 529 account is that you can change the beneficiary of the account, providing flexibility as additional children or grandchildren are born (or do not seek out higher education as expected).
Overall, a 529 plan account is an excellent tool for those who wish to save for educational expenses, and it offers the convenience of a single plan that can be used for the entire family. These accounts are easy to set up, with standardized provisions governing their structure.
A child IRA is no different than an adult IRA, as far as the IRS is concerned. Contributions to an IRA must be made with earned income and cannot be funded using gifts. When a child is earning income to which he or she doesn’t need immediate access, an IRA can still have significant long-term benefits.
Just like an adult IRA, a child IRA can be set up as either a traditional or Roth IRA. A traditional IRA allows an immediate deduction for income taxes when contributions are made, with no principal or income being taxed to that child until they withdraw funds in the future (hopefully at the time of retirement). In contrast, a Roth IRA provides no immediate tax deductions, but any income earned on assets in a Roth IRA is tax-free, including when distributions are made to the child in the future, as long as they are at least age 59½ and have held a Roth account for at least five years.
While there are contribution limits and other requirements to consider, the general rule is that a Roth IRA is the preferred approach when the income-earner expects to be in a higher tax bracket upon retirement than they are right now. Most younger children with earned income can be safely assumed to earn more income (and face higher tax brackets) in their later years. As such, most child IRAs will take the form of a Roth plan.
As with custodial accounts, these accounts ultimately belong to and must be used exclusively for the benefit of the child. Because beneficiaries will ultimately exercise control when they reach the age of majority, those creating IRAs for their heirs must trust that they will be able to resist the temptation to drain their accounts early, triggering 10% penalties for withdrawing before retirement age. For this reason, gift givers should carefully consider the implications before establishing child IRAs.
The most versatile way to make gifts to minors is by establishing a trust. There is no one-size-fits-all approach to creating a trust, and the tax rules can change and be difficult to understand. For this reason, these trusts can be complicated and should only be set up with the aid of an estate and trust attorney.
A trust is a private agreement that names a trustee who will manage property for a beneficiary or beneficiaries. The terms of the agreement can be almost anything you could imagine. Depending on state law, trusts can be structured to be fully asset-protected for a beneficiary's lifetime (i.e., not subject to claims by that child's creditors or a divorcing spouse). This provides wide flexibility, allowing gifts to be used for purposes as specific or as varied as you intend.
Unlike standardized custodial and other accounts, there is no set age or condition for a beneficiary to obtain full access and control of their fund. This is entirely up to the person who created the trust. That person can also decide what happens to funds remaining after the death of a beneficiary, instead of letting the beneficiary make that decision.
A trust could be the only advisable way to make gifts when there are special circumstances, such as a beneficiary with special needs who must be able to maintain public benefits such as Medicaid. With careful structuring, trusts can address contingencies and more precisely meet intended goals better than other types of accounts.
The biggest downside is that trusts can be expensive to set up and must be done with the help of a knowledgeable estate planning attorney. With larger estates, there may also be tax considerations: Trust income could be taxable as a separate entity, it may be taxed directly to the gift-giver, or it could even be taxed to the beneficiary.
The bottom line is that trusts allow gift givers to structure their gifts however they see fit. Trusts can be set up for a single beneficiary or for a group of children or other descendants, increasing investment power from pooling assets. Given the cost of establishing a trust and the more complex rules, trusts are best for sizable gifts that will justify the time and expense of creating and understanding how to administer the trust.
The tail tends to wag the dog when it comes to making gifts. It’s important to keep up to date on the laws, especially tax rules, in order to maximize the value of gifts and ensure desired outcomes.
Even the most common gifting strategies involve an overlap of skills and knowledge from attorneys, accountants and wealth advisers. These are complicated, multidisciplinary issues, so make sure you are working with experts across these disciplines.
This article was written by Jack R. Hales Jr., J.D. from Kiplinger and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to firstname.lastname@example.org.
The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.