Many parents are under the impression that they can give no more than a certain amount of money to their children each year without incurring a penalty or tax. For most people, this is not true. While it is true that the IRS allows individuals to give away $15,000.00 per year without having to file a gift tax return, the only individuals that need to limit their annual gifts are those that will have an estate that will be subject to federal estate taxes upon their death. This is because the federal estate tax system and the gift tax system are related, meaning that large lifetime gifts will reduce the number of assets that can be left to children free of estate taxes.
For example, if a parent gives away $50,000.00 to one child in a year, the IRS will disregard the first $15,000.00 of this gift. The remaining $35,000.00 of the gift reduces the parent’s estate tax exclusion (the amount the parent can leave to the children without paying any estate taxes) by $35,000.00. This reduction, however, is meaningless to most people. This is because most people will never owe federal estate taxes (for people dying in 2019, only estates in excess of $11,400,000.00 are subject to federal estate taxes). Therefore, even large gifts (over $15,000.00) to children will usually not cause any increase in taxes for most parents.
The recipient of a gift (usually a child) never reports the gift as income on their income tax return. A gift is not like earning interest on a bank account or receiving a dividend, or money that the child earned from a job. So gifts are not characterized as income. The only person who ever pays a tax on a gift is the person giving the money away and as stated above only if total lifetime gifts exceed $11,400,000.00 during someone’s lifetime.
It is important to keep in mind that gift and estate tax issues are usually not the only issues to consider when contemplating a gift. The most important consideration is making sure that parents retain enough funds to maintain their chosen lifestyle and to live with the security of knowing that their assets are sufficient to last their entire lives.
Many individuals wish to make gifts to their grandchildren. When considering larger gifts, care needs to be taken to ensure that these gifts qualify for the annual gift tax exclusion. The gift tax exclusion (currently $15,000.00) is the amount the IRS allows individuals to give away each year without having to file a gift tax return and without reducing their federal estate tax exemption (the amount individuals can leave to their family at death without paying estate taxes).
Most individuals do not feel comfortable making gifts directly to minors (grandchildren under 18 years of age) due to concerns the money will not be used wisely. One of the simplest ways to make legally valid transfers to a minor without giving them control of the money is to establish a UTMA (Uniform Transfers to Minors Act) account. UTMA accounts can be established with most financial institutions. The accounts are set up with a custodian (usually the parent of the minor) holding the funds for the minor’s benefit.
The funds in a UTMA account can be used on behalf of the minor until full disbursement to the minor – this must occur when the minor reaches 21 years of age (some States allow for later distribution ages). Once the UTMA account is established, the minor, for income tax purposes, owns the account. This means that the minor is subject to income tax on the earnings in the account. However, in most situations where the beneficiary of the account is under 18 years of age, the parents will elect to report the UTMA account income on their tax return.
Another simple method of making a gift to a young beneficiary is to establish a 529 account. 529 accounts are investment accounts specifically designated to pay for educational expenses. Earnings grow tax‑free and, as long as the money is used for qualified education expenses, withdrawals, including the earnings portion of a withdrawal, are income tax‑free.