The Most Efficient Estate Planning Way to Help the Grandkids

There are many ways you can help a grandchild or child. There are so many Estate Planning options that people are confused and often procrastinate about helping because they aren’t sure which route to take.

Let’s look at the better options and examine the pros and cons of each.

Estate Planning Strategy #1

529 savings plans. These plans provide a large number of benefits. Since the goal of helping children and grandchildren often is to pay for higher education expenses, it makes sense to use a vehicle designed for that purpose. A 529 savings plan is an IRA-like account generally offered through a state or an agency set up by the state. All states offer them now, and most offer multiple options.

Anyone can set up a 529 savings plan account for a beneficiary, and anyone can contribute to it. The person who sets up the account is the owner. The owner directs the investments from among the options offered by the plan sponsor and can name and change the beneficiary. The owner also can take some or all of the money back.

There are substantial tax benefits. The state might allow a deduction against state income taxes for contributions, though there is no federal deduction. Income and gains are tax-free as long as they remain in the account, and distributions are tax-free to the extent they are used to pay for qualified education expenses for the beneficiary.

In addition, you can use up to five years of annual gift tax exclusions in one year. The annual exclusion in 2013 is $14,000 for each beneficiary. Gifts above that amount either reduce your lifetime estate and gift tax exemption or are taxable gifts if your exemption is used up. But with a 529 account you can deposit $70,000 into the account for a grandchild this year, and you and your spouse jointly can give $140,000. That uses five years worth of annual exclusions to that person.

Unlike some other options, the 529 plan allows significant changes. If your financial situation changes, you can take the money back, though you might owe a penalty up to 10%. You also can change the account’s beneficiary.

The 529 plan can be very low-cost, depending on which plan you select. Many states offer very low-expense plans. You also can choose plans with higher fees, especially if you want someone to manage the investments.

Estate Planning Strategy #2

Coverdell accounts. For smaller amounts, you receive many of the same benefits by establishing a Coverdell Education savings account for a beneficiary. These haven’t been popular because they had an expiration date and a $2,000 annual contribution limit. The contribution limit still applies, but Coverdells now are permanent under the fiscal cliff deal. As with 529s, the earnings of a Coverdell aren’t taxed, and distributions used to pay for qualified education expenses are tax free.

A Coverdell can be invested in almost anything. The accounts are sponsored by brokers or mutual funds, and the account can be invested in anything the sponsor allows. Another benefit is that tuition for elementary and secondary schools count as qualified education expenses. For a 529 plan, only higher education and graduate education qualify.

For people who want to save and invest for pre-college tuition or for those with relatively modest amounts to give, a Coverdell is a good choice. For those with more to give, a Coverdell combined with a 529 plan or just a 529 plan can be a good strategy.

There are no federal or state income tax deductions for Coverdell contributions. So, people in a state that offers 529 deductions might prefer the 529 to the Coverdell.

Estate Planning Strategy #3

UGMA/UTMA accounts. The traditional way to help children and grandchildren is to put money in a Uniform Gifts (or Trust) to Minors Act account. The name depends on the state. I’ve cautioned against these, because the child becomes full legal owner after reaching the age of majority, which is 18 in most states. Then, the child can spend the money however he or she wishes.

These accounts also don’t offer significant tax breaks. The main break is the income and gains are taxed at the child’s tax rate. But if the income exceeds a modest amount around $1,000, under the kiddie tax it is taxed at the parents’ top tax rate. The 529 and Coverdell accounts are tax-sheltered. Advantages of the UGMA/UTMA accounts are they can be invested in almost anything, and proceeds can be spent on anything that benefits the child but is not a legal support obligation of the parents.

Estate Planning Strategy #4

Trusts. The wealthy always have resorted to trusts. They allow strong controls and restrictions to be imposed by the grandparents and also can be invested in almost anything and spent on almost anything. There’s no limit on the amount that can be put in a trust. Large gifts would use up the annual gift tax exclusion and either reduce the lifetime estate and gift tax credit or trigger gift taxes.

The income and gains of the trust will be taxed to either the trust or the grandchild who is beneficiary, depending on the terms of the trust. Under the tax tables, trusts hit the top rate at very low incomes. The grandchild’s tax situation is the same as for UGMA/UTMA accounts. Income is taxed at the grandchild’s rate until a low ceiling amount is reached, and then the excess is taxed at the parents’ top tax rate.

There are many types of trusts with different terms. Generally, if you set up an irrevocable trust, you won’t be able to get the money back and probably can’t change the beneficiary, but it has more estate and income tax benefits. Trusts also are expensive to set up and operate each year. You probably don’t want to set one up unless you’re considering contributing $250,000 or more.

Estate Planning Strategy #5

Direct gifts. You always can give directly to either the grandchild or the parents. The only income tax advantages are that income and gains will be taxed at the new owner’s rate, which might be lower than yours. Gifts above $14,000 annually either reduce your lifetime estate and gift tax exemption or incur gift taxes. There usually are no costs to making the gifts or restrictions on investments and spending by the recipient.

The main downside of direct gifts is you don’t know what will be done with the money. It might be invested poorly or spent on things you didn’t intend. Another downside is the direct gifts could reduce the financial aid available to the grandchild. Assets in the grandchild’s name most heavily reduce aid, and assets in the parents’ names also reduce aid.

Estate Planning Strategy #6

Keep the money. You could keep the money in your own accounts and give only when it’s time to spend. With the $5.25 million estate tax exemption, the estate tax incentive to remove assets from an estate and give early doesn’t apply to most people today.

By keeping the money you forego the income tax benefits of vehicles such as 529 and Coverdell accounts or even shifting it to a lower-bracket relative. Retaining the money also limits your gifts in any year to $14,000 per beneficiary ($28,000 if you and a spouse give jointly). But tax-free gifts are unlimited when you make payments directly to a provider of education or medical services.

You have the ultimate control by keeping the money until it is needed. You choose the investments, and you have complete freedom to change your mind until the money is given.

Problems with financial aid also are avoided. Under the financial aid formula, a child’s personal investment assets generally are considered to be spent at a rate of about one third per year for college expenses when calculating financial need. But assets held in the parent’s name generally are assumed to be spent only at about a 4% rate annually for a child. Assets held in a grandparents’ name aren’t counted in the financial aid formula at all. The exact formula depends on the school. If financial aid is a possibility, you want to consider the aid formula when structuring how to help the grandchildren.

RW April 2013.