08/31/2015: Contributed by Greg Middendorf, CFP® CCPS® Partner | Wealth Advisor | Certified College Planning Specialist
There are many ways to make “tax-smart” transfers to younger children and grandchildren. There's no one-size-fits-all answer. The right choice will depend on the child's life stage, the goal of financial assistance, and how much you intend to give.
Set up a Uniform Gifts to Minors Act/Uniform Transfers to Minors Act account (UGMA/UTMA)
UGMA/UTMA accounts provide a way to save on behalf of a minor child without setting up a trust fund. As a donor, you appoint yourself or other adults (such as the child's parents) to look after the account. One of the key advantages is flexibility: You can put a wide range of investments inside a UGMA/UTMA, including stocks and mutual funds. If you're saving fairly small sums, these accounts can be a good choice, but there are two major disadvantages.
- The first is that the assets become the child's property when he or she reaches the age designated under the law of the relevant state. This leaves the donor with no control over how the money is spent.
- The second is that for college-bound children, substantial UGMA/UTMA assets can work against them in financial-aid calculations.
Contribute to a 529 Plan
- First, the assets are the property of the account owner, not the child. So if the original beneficiary doesn't end up going to college, you can use the 529 assets for another college-bound student.
- Second, because 529 plan assets are considered the property of the account owner, they may have a relatively limited impact on financial-aid eligibility. In addition, you won't owe taxes on 529 plan investment earnings and withdrawals, provided they are used to pay for qualified higher-education expenses, such as tuition and room and board. Finally, you may be eligible for a state tax break on your contribution to a 529 Plan.
529 plans are tax-deferred college savings vehicles. Any unqualified distribution of earnings will be subject to ordinary income tax and subject to a 10% federal penalty tax. Here is a list of Ohio 529 Savings Plans.
Fund a Roth IRA
For children who have not yet started their careers, funding a Roth IRA is a good idea. If your child or grandchild is older and working, you can contribute an amount equal to his or her earned income, up to $5,500, to a Roth IRA. If they don’t have any earned income, they can work for you. There are no investment minimums or age limits on contributions, and the Roth grows tax-free for their lifetime. While the original contributions to a Roth IRA can be withdrawn at any time and for any reason, those who need to tap the investment earnings may owe taxes and penalties depending on the circumstances. Despite the tax benefits, Roth IRAs carry one of the drawbacks that accompany UGMA/UTMA accounts: the child has control over the assets and can use the money for whatever he or she wants. Therefore, you need to ensure that the child is educated about the magic of tax-free compounding.
Funds in a traditional IRA grow tax-deferred and are taxed as ordinary income when withdrawn. Contributions to a Roth IRA are not deductible, but funds grow tax-free, and “qualified” distributions can be withdrawn tax free if assets are held for five years. Income tax and a 10% penalty may apply for withdrawals prior to age 59 1/2.
Please consult your tax professional for advice specific to your situation. Give our office a call if you have any questions. Greg Middendorf, CFP® CCPS® Partner | Wealth Advisor | Certified College Planning Specialist