Four options for transferring assets to children - Personal Finance

Healthcare Financial Management, April, 1996 by William G. Kistner

Parents who want to set aside funds for a child's college education or to meet other long-term goals have numerous options. The option they choose will depend on what is more important to them: maintaining control over the assets or reducing their tax burden.

Individuals who elect to maintain assets in their own names pay taxes on those assets. While tax savings can be achieved by transferring the assets to a child, this strategy has several limitations. Moreover, there is always the question of whether a child can be trusted not to squander the assets set aside once he or she reaches adulthood.

Four vehicles exist that can help parents achieve a tax savings through a transfer of assets to a child. These vehicles include: 1) the custodial account, 2) a trust for minors, 3) an IRC section 2503(b) trust, and 4) a Crummey trust.

Custodial Account. Many banks, brokerage firms, and mutual fund companies offer custodial accounts under the Uniform Gifts/Transfers to Minors Act (UGMA/UTMA). Generally, there is no special cost, and these accounts are simple to establish. Under current tax laws, the annual gift tax exclusion permits a person to transfer, tax free, up to $10,000 annually to a custodial account.

While the laws vary among states, a custodial account usually allows a child to be designated the beneficiary of the account and allows the donor to select a custodian to oversee the account until the child reaches age 18 or 21.

If a parent names himself or herself as custodian and dies before the child assumes control, the assets will be included in the taxable estate. To avoid this, one parent can make the other parent the custodian.

Earnings on the investments in a custodial account are treated as taxable income to the minor, and unearned income received by a child under age 14 that exceeds a certain amount annually ($1,300 in 1996) is taxed at the parents' marginal tax rate. While the so-called "kiddie tax rules" on which this limitation is based limit the tax advantage of transferring assets to a minor child, it is beneficial to shift at least $1,300 of earnings to a child. The advantage is that the child will pay only $98 in Federal tax on $1,300, rather than the estimated $650 the parents would pay at their highest combined Federal and state rates.

A disadvantage of the custodial account is that such gifts to it are irrevocable. Even if the parent who set aside the money is the custodian, he or she cannot take it back if it is needed later. The child automatically gains control of the money in the account when he or she reaches majority age.

Parents should consider funding a custodial account with tax-exempt securities since the account will be subject to the "kiddie tax." Moreover, if growth stocks are selected, taxes can be deferred until the child is at least 14 years of age since capital gains are not taxed until the securities are sold. Another potential benefit of funding an account with securities is that stocks are less liquid than cash, and this may discourage a child from squandering the funds once he or she gains control of the account upon reaching age 18 or 21.

Minor's Trust. Establishing a minor's trust is another way to keep a child's college fund out of reach until he or she enters college; however, a parent has to decide whether or not contributions to the trust are to be considered gifts of a present interest. If the contributions are not gifts of a present interest, they will not qualify for the annual exclusion.

Under the Internal Revenue Code, a transfer to a trust established for a minor qualifies as a present interest as long as the minor has access to the assets upon reaching age 21. Before then, the income from the trust either can be accumulated or used for the minor's benefit.

If the child does not have access to the assets until age 21 but starts college at age 17 or 18, the assets in the trust will not be accessible until several years of school have been completed. In this situation, the trustee can be granted the authority to distribute funds for the child's college education. However, if the parent is the trustee and exercises this power while the child is a minor, the parent will be taxed on the income and the property will be included in his or her estate. If the parent chooses, the child, at age 21, can be given a right of withdrawal--a right that will last for only 30 days--after which period the assets will remain in the trust.

Investment earnings that accumulate in a minor's trust are taxed at the same rates that apply to other trusts. Income over $1,600 in 1996 is taxed at 28 percent; the highest Federal tax rate (39.6) applies when the annual trust income exceeds $7,900. Even for those individuals who are in the top tax bracket, the net effect of the trust on tax savings may be only marginally better than the "kiddie tax." Adding to the cost is the upfront legal fee to set up the trust, as well as any tax return preparation and trustee fees.

IRC Section 2503(b) Trust. Under an IRC Section 2503 (b) Trust, parents can create a trust that allows most of their gift to qualify for the annual gift tax exclusion, without giving a child access to the trust assets until he or she reaches adulthood. This can be done by requiring the trust to pay out its income annually, either to the child or to a custodial account, which then can be used for the child's benefit or accumulated until he or she reaches majority age. The actuarial value of the income right, which would last for the child's life or until a set age, qualifies for the annual exclusion. The remainder is a taxable gift that would use up a small part of the unified gift and estate tax credit.