Paul O. Dillon, Attorney at Law

What Is the Best Way to Leave Money to Children?

Parents and grandparents want what’s best for children and grandchildren. We love generously sharing with them during our lifetimes—family vacations, values and history. If we can, we also want to pass on a financial legacy with little or no complications, explains a recent article titled “4 Tax-Smart Ways to Share the Wealth with Kids” from Kiplinger.

There are many ways to transfer wealth from one person to another. However, there are only a handful of tools to effectively transfer financial gifts for future generations during our lifetimes. UTMA/UGMA accounts, 529 accounts, IRAs, and Irrevocable Gift Trusts are the most widely used.

Which option will be best for you and your family? It depends on how much control you want to have, the goal of your gift and its size.

UTMA/UGMA Accounts, the short version for Uniform Transfers to Minor or Uniform Gift to Minor accounts, allows gifts to be set aside for minors who would otherwise not be allowed to own significant property. These custodial accounts let you designate someone—it could be you—to manage gifted funds, until the child becomes of legal age, depending on where you live, 18 or 21.

It takes very little to set up the account. You can do it with your local bank branch. However, the funds are taxable to the child and if an investment triggers a “kiddie tax,” putting the child into a high tax bracket and in line with income tax brackets for non-grantor trusts, it could become expensive. Your estate planning attorney will help you determine if this makes sense.

What may concern you more: when the minor turns 18 or 21, they own the account and can do whatever they want with the funds.

529 College Savings Accounts are increasingly popular for passing on wealth to the next generation. The main goal of a 529 is for educational purposes. However, there are many qualified expenses that it may be used for. Any income from transfers into the account is free of federal income tax, as long as distributions are used for qualified expenses. Any gains may be nontaxable under local and state laws, depending on which account you open and where you live. Contributions to 529 accounts qualify for the annual gift tax exclusion but can also be used for other gift and estate tax planning methods, including letting you make front-loaded gifts for up to five years without tapping your lifetime estate tax exemption.

You may also change the beneficiary of the account at any time, so if one child doesn’t use all their funds, they can be used by another child.

From the IRS’ perspective, a child’s IRA is the same as an adult IRA. The traditional IRA allows an immediate deduction for income taxes when contributions are made. Neither income nor principal are taxed until funds are withdrawn. By contrast, a Roth IRA has no up-front tax deduction. However, any earned income is tax free, as are withdrawals. There are other considerations and limits.  However, generally speaking the Roth IRA is the preferred approach for children and adults when the income earner expects to be in a higher tax bracket when they retire. It’s safe to say that most younger children with earned income will earn more income in their adult years.

The most versatile way to make gifts to minors is through a trust. There’s no one-size-fits-all trust, and tax rules can be complex. Therefore, trusts should only be created with the help of an experienced estate planning attorney. A trust is a private agreement naming a trustee who will manage the assets in the trust for a beneficiary. The terms can be whatever the grantor (the person creating the trust) wants. Trusts can be designed to be fully asset-protected for a beneficiary’s lifetime, as long as they align with state law. The trust should have a provision for what will occur if the beneficiary or the primary trustee dies before the end of the trust.

Reference: Kiplinger (May 15, 2022) “4 Tax-Smart Ways to Share the Wealth with Kids”

Can I Leave My IRA to My Minor Child?

Investopedia’s article, “Designating A Minor As An IRA Beneficiary,” explains that one special case to ponder is the ramification of leaving one or more of your IRAs to a minor. Let’s look at some of the advantages and disadvantages of this strategy.

There are a few reasons why someone might want to leave an IRA to a beneficiary, who’s not yet reached the age of majority.  It is obvious that with a minor child, IRAs can allow much greater flexibility and potential for long-term growth than something like a savings bond. IRAs don’t have to be used for higher education or any other specific purpose to avoid taxation. Young beneficiaries also receive the benefit of a lower required minimum distribution (RMD) over their lives, because the life expectancy of the beneficiary is used when calculating their RMDs.

However, minors can’t own legal property of any kind in their name. Instead, a guardian must be appointed to manage the property for the child, until they reach the age of majority. If the owner of the IRA doesn’t appoint one, a judge will do it. That guardian may have very different ideas about how the account should be handled.

There are some other options you can have your guardian implement, once your beneficiary receives the IRA. He can place the distributions in a custodial account, pursuant to the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA).  However, this could have adverse tax consequences for whoever claims the minor as a dependent on their tax return. If the minor's income is above a certain level, then the parent or guardian must pay tax on the excess at their top marginal tax rate. This option also gives the minor sole custody of the property at the age of majority, when she may not be ready to handle a large sum of money.

A second option is to put the money into a 529 plan. This account lets the assets grow tax-free, until they’re used to pay for higher education expenses.  However, if the beneficiary doesn’t pursue a college education, the plan can also backfire.

Another answer may be to substitute a carefully drafted revocable living trust as the “designated beneficiary” for the IRA and make the minor child the beneficiary of the trust. The guardian would be appointed as the trustee. A trust allows the creator to provide specific directions on how you want the guardian to handle the IRA distributions for the minor.

Consider these alternatives, if you want to leave your IRA to a minor beneficiary. Talk to your IRA custodian about beneficiary requirements, and then speak with an experienced estate planning attorney.

Reference: Investopedia (2018) “Designating A Minor As An IRA Beneficiary”