Gifting money can make a big difference in the life of a child or grandchild. Whether it be providing the financial resources to attend the college of their dreams or setting aside funds to assist your loved ones when they venture out on their own, there are no shortage of options to consider.
This blog post will focus on six of the more common techniques. However, before we begin, it’s important to understand the potential tax implications when gifting.
Note the Annual Gift Tax Exclusion and Federal Lifetime Gift and Estate Tax Exemption
Before gifting money or property, it is important to understand the annual gift tax exclusion and the federal lifetime gift and estate tax exemption. Gifting to younger children and grandchildren follows similar tax rules as gifting to adults.
In 2024, an individual can gift up to $18,000 to as many recipients as he or she wants within a calendar year, while a married couple has a combined gifting limit of $36,000 per recipient. In 2025, the annual gift tax exclusion will increase to $19,000 for individuals and $38,000 for married couples.
Gifts exceeding the $18,000 annual exclusion amount must be reported on a federal gift tax return. In most cases, gift tax will not be due. The gift tax return will report the gift and determine how much of the donor’s lifetime federal gift and estate tax exemption will be used. The lifetime federal gift and estate tax exemption is currently $13,610,000. For married couples, this amount is $27,220,000.
Once the lifetime federal gift and estate tax exemption is exhausted, additional gifts in excess of the $18,000 annual exclusion amount may incur gift tax. If gift tax is due, it is the individual making the gift, not the recipient, who is responsible for paying the tax.
Now that we have covered the potential tax implication of gifting, let’s review six common ways in which gifts can be made to younger children and grandchildren.
Opening Custodial Accounts
The Uniform Gift to Minors Act (UGMA), and by extension the Uniform Transfers to Minors Act (UTMA), allows minors to receive gifts in an account managed by an appointed custodian until they become of legal age in the state in which they live. Most often, the custodian of the account is a parent or other relative.
The major difference between an UGMA account and an UTMA account is the type of asset that each account can hold. UGMA accounts can hold only cash and financial investments, while an UTMA account can hold a wider range of assets. In addition to cash and financial investments, an UTMA account can also hold real estate, paintings, royalties, and patents.
UGMA/UTMA accounts are easy to establish and can provide an efficient way to make larger gifts to a minor without setting up a trust. Once the beneficiary reaches the “age of majority”* in his or her state (*note different states have differing ages of majority which can also differ between UGMA vs. UTMA within the state), he or she takes control of the account. This can sometimes be an exceptionally large amount to receive at once, particularly if the assets have grown over time. For individuals who want more oversight in the distribution of funds, it may be worth setting up a trust or exploring other options when gifting to minors.
Setting Up a Trust
Trusts can be established for the benefit of children and grandchildren, with the distribution of funds outlined in the trust agreement. The trust mechanism offers flexibility and is often utilized in situations where an individual would like to gift a large sum of money and would like to maintain control over how the funds are used or the timing of the distributions.
Trusts can be set up for the benefit of only one beneficiary or for the benefit of two or more beneficiaries. Common provisions allow the trustee to make distributions to the beneficiary or beneficiaries to provide for their health, education, maintenance, and support. A timeline for distributions based on age or upon the occurrence of specific events can also be incorporated into the trust agreement.
Trusts can also be drafted in such a way to provide an additional layer of protection from future potential creditors of a child or grandchild. This will help the gifted assets to stay in the family versus being distributed to a third party outside the family.
Another reason to consider a trust is for estate tax planning purposes. Gifting a large sum of money to an irrevocable trust for the benefit of children or grandchildren is a common strategy for reducing an individual’s estate tax exposure, whether at the federal level, state level, or both.
While setting up a trust offers many benefits, it is important to note that this option can be complicated and expensive.
Funding a 529 Plan
If funding education costs is a priority, gifting cash to a 529 plan could be a powerful option. A 529 plan provides a tax advantaged way to help pay for education expenses. Earnings on funds within the 529 plan grow tax-deferred, and withdrawals are tax-free if used to pay for qualified education expenses. Qualified education expenses are broadly defined to include tuition, fees, room and board, and other related costs associated with attending college or graduate school. In addition, up to $10,000 per year can be withdrawn tax-free to pay elementary, middle, and high school tuition at private and parochial schools.
The earnings on any withdrawals used for nonqualified educational expenses are subject to income tax and a 10% penalty.
Cash transferred to a 529 plan qualifies as an annual exclusion gift. Contributions to a 529 plan can also be frontloaded by gifting up to five years’ worth of annual exclusion gifts at once without impacting the individual’s lifetime federal gift and estate tax exemption (subject to certain parameters). Frontloading a 529 plan, especially if the beneficiary is young, offers the advantage of giving the money more time to grow. In addition, money gifted to the 529 plan may reduce the value of your estate for estate tax purposes.
The individual who establishes the 529 plan becomes the owner of the account and can designate the initial beneficiary of the account. The owner may transfer the 529 plan once per year to a different beneficiary, provided the new beneficiary is another family member (with certain restrictions on who qualifies as a relative).
Anyone can open a 529 plan on behalf of a beneficiary, but typically parents or grandparents open them. There are also many 529 programs that are administered by state governments with varying rules. For instance, some states provide a state income tax deduction or credit for 529 plan contributions.
Beginning in 2024, funds within a 529 plan can be rolled directly into a Roth IRA for the beneficiary of the account (subject to stated parameters).
Gifts Intended for Tuition Expenses
There is a special provision in the IRC that allows individuals to pay an unlimited amount for a student’s tuition and not be subject to the gift tax rules. Tuition payments must be made directly to an accredited educational institution.
It is important to note that funds cannot be given directly to a student with the expectation that the student will then pay the tuition. The tuition payment must be paid directly to the student’s school by the individual making the gift.
The payment made to the school can only cover tuition. It may not be used for other educational expenses, like room and board or textbooks.
Gifts Intended for Medical Expenses
There is also a special provision in the IRC that allows individuals to pay an unlimited amount for qualifying medical expenses incurred by someone else.
The definition of “qualifying medical expenses” for someone’s medical care includes amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care.”1 It also includes amounts paid for medical insurance on behalf of any individual directly to the insurance provider. It does not include medical expenses that are reimbursed by insurance, nor does it include medical treatment for cosmetic purposes.
Such payments must be paid directly to the health care provider or facility. Reimbursing someone for medical expenses they previously paid does not qualify for this exclusion.
Investing in Roth IRAs
Investing in Roth IRAs is an option that is often overlooked by individuals looking to provide for children and grandchildren.
If a child or grandchild is earning income, perhaps from a part-time job, a parent, grandparent, or other adult can gift money directly into a Roth IRA in the name of the child or grandchild. In 2024, an amount up to $7,000, or the amount of earned income that the child or grandchild makes, whichever is less, can be contributed on behalf of the child or grandchild to a Roth IRA.
Roth IRAs offer many advantages. Money contributed to the Roth IRA will grow tax-free. In addition, the contributions and any gain can be withdrawn by the child or grandchild tax-free when they reach age 59½. Contributions to the Roth IRA can be used to pay for qualified education expenses penalty-free. However, any gain that is distributed from the Roth IRA prior to age 59½, even if used to pay for qualified education expenses, will be subject to income tax.
The Right Gifting Option Depends on Your Situation
There are many options available when gifting to children and grandchildren. This blog post addressed the most common techniques and strategies. Each has benefits and considerations based on specific situations, goals, and objectives.
It is important to review and discuss your options with your estate planning attorney and tax advisor.
If you are interested in discussing your options further, please reach out to your team at Boston Trust Walden.