Grandparents, Be Smart About Giving Money This Holiday Season

My father used to spend weeks pacing shopping malls and looking through catalogs every holiday season, only to ultimately give us an elaborately wrapped box containing a gift card or cash. He would always explain how sorry he was for how impersonal it seemed, but he just couldn't find anything that would be more useful to us than money.

And luckily for my dad, he had some very like-minded children. We would always reassure him that not only had he chosen the perfect gift, we knew how much thought and love had gone into it.

Indeed, giving money can be very personal. You can use it to help fund your grandchildren's future college education, and even help them choose their first investments and learn about compounding firsthand.

But not only is it good for the recipient, gifting money is a good way to minimize your future estate taxes. Here are some ideas for gifting money, and some considerations you'll want to be aware of for each.

Gift Idea #1: Contribute to a 529 Account Helping your grandchildren pay for their college education is one of the most valuable gifts you can give.

In 2017, you are allowed to give up to $14,000 to any individual with no gift tax (or generation-skipping transfer tax if the beneficiary is your grandchild). Your spouse can do the same, which means you can jointly give $28,000. You can also "superfund" a 529, which means you make an upfront contribution of up to $70,000 (or up to $140,000 for a married couple) to a beneficiary's plan, then treat the contribution as having been made over a five-calendar-year period for gift-tax purposes (by filing IRS form 709 with your federal tax return in each of those five years).

A benefit of superfunding is that the money gets out of your estate faster than if you made contributions each year, which could be beneficial from an estate-tax perspective. Be aware, though, that any amount in excess of $14,000 per year must be counted toward the individual's lifetime gift-tax exclusion limits (the federal lifetime limit is currently $5,490,000 per individual, and under the proposed tax bill, is set to double in 2018, so it's not an issue for most).

The most straightforward way is probably to contribute directly to the beneficiary's existing 529 plan, if that plan allows contributions from third parties. To find out if your grandchildren's plan does and what the best procedure is, call the plan's toll-free number and speak to a customer service representative.

States have different rules regarding whether third-party contributors can claim a state tax benefit. In Illinois, for instance, if you are a nonaccount holder but an Illinois resident contributing to Illinois' Bright Start College Savings program, you can take the state income tax deduction for the contribution up to $10,000 per individuals and $20,000 per couple, and the contribution must be made by Dec. 31.

There are a handful of states that allow you to take a state tax deduction for contributing to other states' plans, but in most states you must be a resident of the state that administers the plan. A small number of states offer in-state residents tax breaks on contributions only if they are the account owner.

In some cases, then, it may make sense for the grandparents to open their own 529 account with their grandchildren as named beneficiaries, especially if they are looking to take advantage of the state tax benefit for contributing. There are some important considerations if you go this route, however.

The first thing to be aware of is that grandparent-owned 529 assets can potentially lower the amount of financial aid benefits the student is eligible to receive, so it's important to understand how they figure into the financial aid calculation. After all, you want to help--not hurt-the student's financial situation!

Assets in 529s owned by the custodial parent(s) are assessed at a maximum of 5.64%; meanwhile, assets that are owned by a grandparent, aunt/uncle, noncustodial parent, etc., are not counted at all, until two years after they are used.

As the money is withdrawn from these noncustodial-parent accounts and used to pay for college, it appears as student income, and that figures much more heavily into the expected family contribution calculation (as much as 50%, as opposed to 5.64%.) This difference is significant because a higher expected family contribution means the student receives less financial aid.

That's not to say that it's a bad idea for grandparents to open 529 accounts for the benefit of grandchildren, it's just wise to be tactical about how and when you use this money. By not using that higher-counted 529 withdrawal in earlier years of college, you will maximize the student's overall aid package.

Gift Idea #2: Contribute to a Roth IRA Another option is to open an individual retirement account in the child's name. Some brokerages such as Schwab and Fidelity offer custodial IRAs with no fees and a low or no minimum balance. To do this, the child must have earned income (from some type of job), and the amount contributed to the IRA each year cannot exceed what she earned (or a maximum of $5,500).

Note that it doesn't have to be the same money that was earned, though; the grandchild can earn $2,500 at a job, spend it, and then a grandparent can set up an IRA in the child's name with $2,500. This is a common question from readers.

For young savers, a Roth IRA is a better choice than a traditional deductible IRA because their tax rate will likely be lower now than it will be in retirement. Roth IRAs are funded with aftertax dollars, and withdrawals, including any earned income, are tax-free after age 59 1/2. Plus, Roth contributions (but not earnings) can be withdrawn tax-free prior to retirement, which means kids can use some of the money for another purpose, such as paying for college. Also, the beneficiary can withdraw up to $10,000 from your investment earnings penalty- and tax-free if he uses it for a down payment on a home.

And, unlike custodial accounts such as a UGMA or UTMA, traditional or Roth IRAs do not factor into the expected family contribution equation when determining how much financial aid your child is eligible for. (Be aware however that any withdrawals you make to help pay for college, though penalty-free when used for qualified educational expenses, will be counted as income in the EFC calculation and could lower the amount of financial aid received two years after they are used.)

Gift Idea #3: Contribute to a Custodial UGMA or UTMA Account If the child doesn't have any earned income, grandparents can still set up or contribute to a custodial account, known as an UGMA (for Uniform Gifts to Minors Act) or UTMA (for Uniform Transfer to Minors Act). These accounts are a way to establish ownership of assets on behalf of a minor while control over the account remains with an adult, such as a parent or guardian. However, once assets are placed in a custodial account they are legally (and irrevocably) the property of the beneficiary. Also, once the beneficiary turns age 18 or 21 (depending on the state) he or she assumes control of the assets.

One consideration with custodial accounts is that the assets inside an UGMA or UTMA account are considered the beneficiary's assets, and thus counted higher (20%) in terms of the financial aid calculation than money in a 529 account (which is counted at a 5.64% rate). Therefore, UGMA and UTMA accounts can have a larger negative impact on the level of aid a student will be eligible to receive.

One thing to be aware of with these accounts is "kiddie tax" rules; because the assets in the custodial account are technically the child's, there is an incentive to shift investment income away from someone in a higher tax bracket (the parents) to someone in a lower tax bracket (the children), in order to pay a lower federal tax rate on the unearned income.

Unearned income consists of dividends, interest, and capital gains distributions from investments. Kiddie tax rules also apply to distributions from inherited IRAs.

There is some leniency to the rules, however. Per the IRS, the first $1,050 of unearned income in the child's name is untaxed and the next $1,050 is taxed at the child's rate. Any unearned income above this level is taxed at the parent's rate (or the child's rate if it's higher).

Further, the same preferential tax rate for long-term capital gains and qualified dividends that applies to adults also applies to kids. As a reminder, long-term capital gains and qualified dividends are taxed at 0% for those who are in the 10% or 15% tax brackets. This means that anyone--adult or child--who has less than $37,950 in ordinary income would not pay taxes on the first $2,100 in investment income.

For any long-term capital gains above the $2,100 threshold, however, the parents' long-term capital gains rate applies. So, if the parents had at least $75,900 (if filing jointly, or $37,950 for a single parent) in ordinary income, the tax rate would be 15% (or 20% for parents in the highest tax bracket) after that initial $2,100.

For short-term capital gains (on sales of securities owned for less than a year) and nonqualified dividends, the child's ordinary income tax rate applies for amounts over $1,050 but below $2,100, and the parents' ordinary income tax rate applies after $2,100.

Note that the kiddie tax rules are being revamped under the proposed tax bill, by effectively applying ordinary and capital gains rates applicable to trusts and estates on unearned income of children.

Financial planning expert Michael Kitces explains how this is likely to affect investors in this Nerd's Eye View blog post: "Under TCJA ... the 'allocable parental tax' (the additional taxes the child pays based on adding their income to their parents' top marginal tax rates) is restructured. Instead of adding the child's income to their parents' tax brackets, the Kiddie Tax will instead be calculated by subjecting the child's unearned income to the trust tax brackets--which ... have a top tax bracket of 37% on any income over $12,500."