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Should Savings Be In The Child's Name Or Not?
This is one of the most frequently asked, and one of the most
frequently misunderstood questions in all of taxes. That's because
it involves three separate decision-making areas: income tax
decisions, estate tax decisions, and financial control choices.
First, let's review ways you can save on behalf of a minor in 2000.
There are three main ways: 1) In a custodial account for the minor;
2) In a trust, or
3) In your name.
Each has its own advantages and disadvantages. However, they all
share a common denominator which is the attempt to shift income and
assets in a most favorable way for income tax and estate tax
purposes. How old the child is, how much savings is at stake, how
long the savings plan will be in effect, and how much you trust the
minor when the age of majority is reached are critical factors in
deciding how title should be set up.
Using A Custodial Account
In order to have the savings legally in a minor's name so you do not
have any income tax consequences of your own, it can be done through
the Uniform Gifts To Minors Act (UGMA), or the latest version, the
Uniform Transfer To Minors Act (UTMA). Basically, these two methods
involve gifting over money to the child, and appointing a custodian
to manage the funds (the custodian can be any adult including
yourself). These accounts are easy to set up with any bank,
brokerage company, money manager, or the like. The child's social
security number must be used since the money is legally the child's
the minute it goes into the account, and taxable to the child.
There are a few differences between the UGMA and the UTMA that
should be noted. A UGMA account automatically gives control of the
funds to the child at the age of 18 while a UTMA account can delay
this until age 21, or in some states even age 25. The UTMA has more
savings options in that the custodian can buy real estate, and
royalty producing investments to name a few.
However, not all states allow the newer UTMA's, although the trend
is moving toward it. As of 1992, there were 27 states allowing this
more liberal custodial account:
Alabama, Arkansas, Colorado, California, Florida, Hawaii, Illinois,
Idaho, Iowa, Kentucky, Kansas, Louisiana, Massachusetts, Minnesota,
Missouri, Montana, New Hampshire, Nevada, New Jersey, North Dakota,
North Carolina, Oklahoma, Oregon, Rhode Island, South Dakota, West
Virginia, and Wyoming.
ADVANTAGES OF USING A CUSTODIAL ACCOUNT
If donors appoint someone other than themselves as custodian, the
funds may escape any of the donor's potential estate taxes and/or
any lawsuits. Also, the income generated by these savings is taxable
in the minor's name, which can result in significant savings if the
bracket for the donor is higher than the child's bracket. This is
usually the case, except when the "kiddie tax" kicks in at certain
ages (we will discuss this shortly). Another positive is that it is
very easy to set up, with no fees, no lawyers required. The yearly
tax return required is a regular income tax return so tax filing can
be quite simple and inexpensive.
DISADVANTAGES OF USING A CUSTODIAL ACCOUNT
One of the main complications from an income tax standpoint is the "Kiddie
tax" problem. This was part of the 1986 TEFRA(Tax Reform Act). In
effect, it said that the tax rate a child would pay on taxable
"unearned income" from savings depended on two things: the age of
the child, and the amount of the taxable income. Under IRS 2000
rules, if the child is under age 14, and this taxable income is over
$1,400 in round numbers, the child pays a tax at a rate the same as
the parents' on all the income exceeding this $1,400 figure. In
effect, the Kiddie tax law makes some custodial accounts much less
attractive since there now exist situations where there is no longer
any tax savings from parent to child above these levels compared to
the old laws. It makes planning much more difficult as well because
one must be able to project out the yearly taxable income and
coordinate it with the child's age in order to maximize the tax
savings.
The game plan now is to have $1,400 or less in unearned income until
the child reaches 14 to minimize taxes, then do an about face–
maximize the taxable income after that age(when the Kiddie tax rules
no longer apply). As you can see, much more attention must be placed
on the type of investments used, the projected yields, the child's
age, and the tax bracket differentials between parents and child
because of this set of tax laws.
Another disadvantage to custodial accounts is that the money is
legally the child's from the time you gift it; when the child
reaches the age of majority, the child can do whatever is wished
with it– even buy a Harley Davidson–and there is nothing you can do
legally to stop this. So you should have a good sense of trust in
the child's future judgment when you set up a custodial account.
Trusts
There are several trusts you can set up, but the most common for
this purpose would be the 2503(c) trust, nicknamed the "minors'
trust." This is complicated to set up, and can be expensive, usually
requiring a lawyer. Also, the yearly tax return that must be filed
(Form 1041) can be quite involved, and expensive to have prepared.
However, it may have certain advantages. First, the trustee can
control the money much better–and longer if it is handled right. In
effect, it can be structured so that the trust can continue long
after the child reaches age 21, thus keeping control of the
principal on behalf of the donor. Second, under the revised 2000 tax
codes, the tax rates may be more predictable on the first $7,500 of
taxable income from the trust regardless of the child's age–unlike a
UGMA or UTMA account, so it is easier to plan the tax consequences
and types of investments. Third, the money in the trust can be
shielded from the donor's creditors in event of a lawsuit. Finally,
it allows for more sophisticated estate tax planning avenues.
Your Own Name
Saving in your own name is a viable choice as well. Although the tax
savings may be less if your tax bracket is higher than your child's,
you retain full control of the funds. When the time comes to use the
money for the child–usually for education–you can gift over the
money in time payments. As long as you make sure the annual gift
amount is $10,000 (adjusted annually for inflation) or less per
person (a husband and wife can jointly give $20,000), you have no
gift/estate taxes to worry about. Also, you can make direct payment
to the educational facility (instead of giving it to the child)
without any dollar amount restrictions for gift tax laws.
The disadvantages are twofold. First, the money is considered part
of your estate, so at death, it may be subject to estate taxes.
Second, since the probability is that your tax bracket is higher
than your child's you may pay more taxes (especially after the child
reaches age 14) with the same type of investments if they are in
your name vs a trust or custodial account.
Of course, a way to get around the higher tax problem is to use
investments that don't produce ordinary taxable income. Naturally,
you should go over these possibilities with an investment or
financial advisor. Some of these alternate investments are:
growth-type investments that appreciate in value instead of paying
interest or dividends(stocks, real estate, etc.); tax exempt bonds;
tax deferred bonds like Series EE Savings Bonds; certain tax
deferred annuities; and company sponsored pre-tax savings plans.
In effect, you can minimize–or optimize–your income tax bracket yet
still retain control and ownership of the investments.
Bottom Line
Using a trust makes sense if the investment in question will be
generating a relatively large enough amount of taxable income before
the minor is age 14 to justify the extra costs of setting it up, and
doing the yearly Fiduciary Income Tax Returns. Also, the spread
between the parents' tax bracket and the trust's must be sufficient
enough to justify it as well. But if you are a typically average
parent saving a typically average amount for your child, the
probability is that this 2503(c) trust would not be the first choice
from an income tax saving standpoint.
As you can see, each option carries with it strengths and
weaknesses. However, the more you feel you can trust your children,
the higher your tax bracket, and the better you can predict the
taxable yields on the investments used, the more favorable a
Custodial Account could be. But if you cannot adequately guarantee
they will use the money for its intended purpose when they reach the
age of majority, think twice about using a Custodial Account!
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