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.
The kiddie tax rules may make gifting to children less effective as a college savings strategy.
Strengths
Shifts income to lower tax bracket
The primary advantage of gifting assets to your child is that, in most cases, children are in a lower tax bracket than their parents. So over time, the money will likely grow to be worth more in the child’s account because the child generally pays income and/or capital gains tax at a lower rate. However, the kiddie tax rules may negate this advantage when the child’s annual unearned income is below a certain amount, as discussed below.
Child retains parents’ cost basis in gifted asset
When you gift an asset to your child that has appreciated in value, such as appreciated stock, your child’s basis (cost) in that asset is considered to be the same as your original cost, not the current value of the property. This means that upon sale of the asset, your child will have the same amount of capital gain that you would have had. The difference is that your child may owe less capital gains taxes if he or she is in a lower tax bracket.
Assume that you are in the 32 percent tax bracket and your child is in the 10 percent tax bracket and you gift 100 shares of stock to your child. You purchased the stock four years ago at $15 per share; it is now worth $60. Your child’s basis in the stock is considered to be $1,500 (100 x $15). If your child sells the stock at its current price, he or she has recognized a $4,500 gain. If your child has little taxable income, his or her capital gains tax rate is zero percent. By contrast, if you had kept the stock and sold it yourself, your gain would have been the same, but you would have owed $675 in taxes due to a 15 percent long-term capital gains rate.
Capital gains tax rates are lower for individuals in 10 and 15 percent tax brackets
Individuals with little to no taxable income generally pay zero capital gains tax on most long-term capital gains. If you gift appreciated assets to your child, your child will have the same basis and holding period in the assets that you had. If you are in a higher income tax bracket than your child, then your child will have some tax savings when the asset is sold compared to if you had sold the asset.
Reduces size of gross estate
When you gift assets to your child, you generally remove those assets from your gross estate. Thus, you reduce the chance your estate will owe estate tax.