A gift is a voluntary transfer of money or property from one person to another person or entity (such as a trust) where the person making the gift receives either nothing or a lesser amount of money or property in return. In the context of education planning, gifting is usually implemented as a strategy when parents want to shift income to their child and reduce taxes. This ability to shift income and reduce taxes works best when the parents are in a high tax bracket and the child is in a low tax bracket.
Tradeoffs
The kiddie tax may limit your tax savings
The kiddie tax rules apply to children who are (1) under age 18, or (2) under age 19 or a full-time student under age 24, provided the child doesn’t earn more than one-half of his or her financial support. Children in these categories are taxed at trust and estate tax rates on all unearned income over $2,100. (The first $1,050 of unearned income is tax free and the next $1,050 is taxed at the child’s rate.)
To minimize the impact of the kiddie tax, parents might consider investing their child’s savings in tax-free or tax-deferred investments so that any taxable income is postponed until after the child reaches age 24 (when the child is taxed at his or her own rate). Such investments can include U.S. savings bonds, tax-free municipal bonds, or growth stocks (which provide little, if any, current income). Alternatively, parents can try to hold just enough assets in their child’s name so that the investment income remains under $2,100.
Transferring assets to child may reduce his or her financial aid award
Under the federal methodology for determining a family’s financial need, a child’s assets can have a greater financial aid impact than his or her parents. Under this formula, a child is expected to contribute 20 percent of his or her assets each year toward college costs, compared to 5.6 percent for parents. So $20,000 in a child’s bank account would translate into a $4,000 expected contribution, whereas the same money in the parents’ account would mean a $1,120 expected contribution.
Gifting assets to your child is irrevocable
Once you gift an asset to your child, your child owns it. That means that your child can use the money for anything, not necessarily college.
Possible gift tax implications
If the sum of the gifts you make to your child each year is equal to or less than the $15,000 annual gift tax exclusion or double that amount for married couples who are U.S. citizens and making joint gifts, the gifts are not subject to federal gift tax (though they may be subject to state gift tax). However, if gifts to your child are over the annual gift tax exclusion amount in a given year, a portion of the gifts may be subject to federal gift tax.
What are the most favorable types of property to gift to your child?
There’s no restriction on the type of property that can be gifted to your child; parents are free to gift any asset they wish. However, some types of assets are more favorable to gift than others due to the tax-saving opportunities. Two of these assets are discussed here: appreciated assets and income-producing property.
Appreciated assets
An appreciated asset is an asset that has a value in excess of the holder’s adjusted tax basis in the asset. Though everyone certainly hopes their assets will appreciate in value, the downside is the capital gains taxes that could result from the sale of such assets.
The strength of gifting an appreciated asset to your child is that if and when your child sells the asset, he or she will be subject to tax on any gains at his or her own rate.
Income-producing property
Income-producing property is just what the name suggests–it’s property that produces income. Examples of such property include rental property, stocks that pay regular dividends, bonds that pay interest, and equipment leases. The strength of gifting income-producing property to your child is that, in most cases, you transfer the income stream to someone in a lower tax bracket than yourself.
Questions & Answers
Is it true that a person can make a tax-free gift of tuition on behalf of a child?
Yes. A tax-free gifts of tuition is a payment of tuition made directly to a college or university on behalf of a student for his or her education. The IRS won’t consider this type of payment to be a gift for purposes of computing federal gift tax. In other words, you can make a gift of tuition for more than the annual gift tax exclusion in a given year, without federal gift tax consequences.
To qualify, the payment must be for tuition only and made directly to the college. You can’t gift the money to the child and then instruct the child to apply the money toward tuition. The gift of tuition must occur at the time your child is actually in college.