Making Gifts to Minors

Highlights:

• Under current tax law, even non-charitable gifts are not taxable, except perhaps in the case of very wealthy donors.
• There are several ways to structure gifts to minors that will safeguard the gifts from creditors, predators, and poor decisions.
• If asset protection is of high importance, a gift to a trust account may be the best alternative.

Gifts to minors can do a world of good or unintended harm.  If structured properly, gifts can be used to pay for educational expenses, provide a financial foundation for the future, or help cover special need expenses.  By contrast, poorly structured gifts can put money in the hands of a young adult before he or she has the experience, maturity and judgement needed to use the gift wisely.

In the past, careful planning was often needed to make sure gifts did not trigger a federal gift tax which could, in some cases, exceed 55%.  However, that’s not the case today, thanks to tax-law changes over the last ten years or so.[1]   

Under current law, all U.S. citizens are entitled to a federal gift tax exemption that shelters lifetime gifts from the federal gift tax.  For 2019, the exemption amount will shelter up to $11.4 million of gifts from the federal gift tax for single persons, and twice that amount for married individuals.  If you are one of the lucky few who would like to make gifts in excess of those amounts, the annual gift tax exclusion allows you to make additional qualifying gifts of up to $15,000 a year to as many people as you would like without incurring a federal gift tax.

In most cases, it is not practical to make significant outright gifts to minors, if for no other reason than the practical concern of how the minor will use the gift.  Fortunately, there are a number of ways to safeguard money given to minors for the child’s future.  

Custodial Accounts

Perhaps the simplest way to make a gift to a young person is via a custodial account in accordance with either the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA).  Both laws allow a donor to place gifts to a minor under the control of a custodian until the child reaches adulthood.

The custodian of an UTMA or UGMA account has the authority to decide how moneys held in the account are to be invested and spent on the minor’s behalf.  The person making the gift, a parent of the child (or any other adult), may be the custodian of the account.  However, assets held by the custodian must be turned over to the account beneficiary when he or she turns 18, (in the case of an UGMA account) or as late as age 25 (in the case of an UTMA account).[2]

Because money placed in an UGMA/UTMA account is owned by the child, the income is taxable to the child at the child’s tax rate unless the child has over $2,200 of investment income.  (To the extent the child has more than $2,200 of investment income, it is taxed at a higher rate because of the “kiddie tax”.)[3]  In addition, custodial accounts can adversely affect the child’s eligibility for college financial aid.

Roth IRAs

Establishing a Custodial Roth IRA for a hardworking minor can be an excellent way to reward him or her for a job well done.  For 2019, you can contribute the lesser of $6,000 or 100% of a child’s earned income to a custodial IRA.

While the child for whose benefit a custodial IRA has been established is regarded as the account owner, he or she will not have control over the account until she reaches the age of majority (either age 18 or 21, depending on the jurisdiction).  At that point, the custodial IRA is converted to a traditional Roth IRA assuming the child does not withdraw the funds.  It’s worth noting that such a withdrawal would trigger taxes and penalties that could prove to be an effective deterrent to a premature withdrawal.

Unlike a traditional custodial account, the income earned by a custodial Roth IRA is not taxed.  In addition, distributions from a Roth IRA are not subject to income taxes either, so long as the distribution is taken after the account owner reaches age 59 ½ (or sooner if the owner is disabled at the time of the withdrawal). 

529 Accounts

If you’d like the dollars that you gift to a minor to be used for education rather than retirement, then a Qualified Tuition Program, more commonly referred to as a 529 Plan, might just be the ticket.  529 plans are tax-favored education savings plans that are sanctioned by the Internal Revenue Code and operated at the state level. 

As in the case of a Roth IRA, the earnings on amounts held by a 529 Plan account are not subject to either state or federal income taxation, and account withdrawals to pay for qualified educational expenses are completely tax-free.[4]  Moreover, although contributions to a 529 Plan are not deductible to the donor for federal income tax purposes, many states allow the donor to deduct part or all of a 529 contribution for state income tax purposes.

A 529 Plan can be owned by either the beneficiary of the account or the donor.  If the donor is the owner, then the donor can change the beneficiary of the account if the original beneficiary does not need the money for his or her education.  If the student does not own the account, then they do not need to be given control of the account at adulthood.

Further, if either the student or the student’s parent is the owner, then the existence of the 529 will probably not have much of an impact on the student’s eligibility for financial aid for college.  However, if anyone else (including a grandparent) owns the account, then distributions for the student’s college expenses may be considered untaxed income of the beneficiary, which could hurt his or her chances for financial aid.[5]  

Gift Trusts

If the goal is to have maximum flexibility regarding when and for what purposes the gifted funds are used, then a gift trust may be the best alternative.  In that case, the trustee can maintain control over the trust assets for as long as the trust agreement directs, regardless of the beneficiary’s age, and can use the funds for any purpose that is permitted by the trust agreement.

A trust agreement that governs a trust can be either revocable or irrevocable.  When the federal estate and gift tax exemptions were smaller, it was common for gift trusts to be irrevocable, in order to keep the trust assets outside of the taxable estate of the person who funded the trust. 

As in the case of gift taxes, under current law only the very wealthy need worry about estate taxes.[6]  As a result, it is quite common for gift trusts to be written such that the trust agreement can be changed, or even revoked, by the person who established it. 

Income earned by a trust account is taxable.  However, the trust can be structured as a “grantor trust,” in which case the trust’s income is reported on the donor’s tax return.  In that event, the trust account will compound without the need to withdraw dollars to pay taxes (because the donor will be paying those taxes).  The disadvantage is that the donor’s personal tax rate may be higher than the rate that would apply to the trust income if it were not a grantor trust. 

Finally, under current law, the income tax basis of investments that belong to a gift trust will be adjusted to their fair market value when the person who created the trust dies if the assets of the gift trust are includable in the estate of the trust creator when he or she dies.  As a result, any appreciation that occurs in the interim will escape income taxation.  This benefit can more than outweigh the higher tax rates that sometimes apply to trust income.

As you can see, there is a lot to consider when making gifts to a beloved little one.  But don’t let that discourage you.   The stakes are high and the potential benefits are well worth the effort.

Thank you for reading.

Andrew J. Willms, JD, LL.M

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[1] Some states impose a state gift tax that can apply to gifts that are not subject to federal taxation, so you should check the laws in effect in your state before making a taxable gift.

[2] UGMAs may only hold financial assets, while UTMAs may also hold non-financial assets, including real estate.  Most states permit UTMA accounts, except Vermont and South Carolina only allow UGMA accounts.

[3] The Tax Cuts and Jobs Act taxes a child’s unearned income in excess of $2,200 at the same rates as paid by trusts and estates, which could be as high as 40.8% (federal), plus state taxes.

[4] The Tax Cuts and Jobs Act expanded the definition of qualified education costs to include K-12 public, private, and religious school tuition, along with post-secondary education costs.

[5] A discussion of possible solutions to this potential problem can be found here: https://www.savingforcollege.com/article/workarounds-for-grandparent-owned-529-plans.

[6] For persons dying in 2019, the amount that can be sheltered from federal estate taxes at death is also $11.4 million.  However, the amount of gift tax exemption a deceased person used during his or her life is subtracted when determining the amount of estate tax exemption available to the decedent’s estate.