Consider tax implications of gifts

Parents or grandparents, particularly those with higher incomes or larger

estates, often wish to make substantial lifetime financial gifts to their

children or grandchildren. They may do so for a variety of reasons, but

two of the most common are to shift some of their income tax liability to

the minor's lower tax bracket (perhaps to build a college fund) and to move

assets out of their estate to reduce estate taxes.

Whatever the reason, making gifts should be done with care, not only

to accomplish your goals and minimize taxes, but also to avoid having the

recipient minor waste the gift.

Remember that any gifts of more than $10,000 a year to a single person

are subject to gift tax.

Also, income the child earns from the assets is subject to the "kiddie"

tax if the child is still under age 14 at the end of the tax year. Under

the kiddie tax, the first $700 in unearned investment income is not taxed.

The next $700 is subject to the child's tax rate, and any investment income

above $1,400 is taxed at the parent's rate. For children 14 or older when

the tax year starts, investment income is taxed solely at their marginal

rate, which usually is 15 percent.

Following are some gift-giving suggestions and warnings.

Outright gift

The simplest form of giving is simply to transfer stock, mutual fund

shares, cash or other property outright to the minor. As a minor, the recipient

will not be able to transact any financial business with the gift — such

as selling and buying stock or property — without a court-appointed guardian.

The guardian probably will be severely restricted as to what he or she can

do with the property. They gift may not even be able to be used to pay for

college if the minor's parents have adequate resources. However, when the

child reaches the age of majority, which is 18 to 21 depending on the state,

the recipient can do whatever he or she wishes with the property.

Custodial account

Particularly popular for funding a child's education are custodial accounts,

which fall under the Uniform Transfers to Minors Act (UTMA) or the Uniform

Gifts to Minors Act (UGMA) depending on the state. You can set up these

accounts with financial institutions such as banks, brokerage firms or mutual

fund companies. The custodian manages the assets until the minor reaches

the age of majority. Investment income is subject to the kiddie tax depending

on the child's age, but you can minimize the income by donating such assets

as growth-oriented stocks or tax-free bonds.

The main drawback to custodial accounts is that the child assumes control

of the assets at the age of majority. The recipient might then spend the

money on a new car or a trip to Europe instead of college.

While parents typically name themselves as custodians for UTMAs or UGMAs,

estate planning experts point out that property in the account will be included

in the custodial parent's estate should the parent die before the custodianship

ends when the child reaches the age of majority.

Trust

Consider using trusts for larger gifts. They are more expensive to set

up but more flexible. With some trusts, you can extend control of the assets

beyond age 21 — say to 25, 30 or even later. However, there are several

tricky tax issues. Another drawback is that trust distributions used to

pay for what would normally be considered legal obligations of the parents,

such as medical expenses, are taxed at the parent's rate instead of the

child's. There also may be a window of opportunity for the child to assume

outright control of the assets. You will definitely want to consult a qualified

estate-planning attorney here.

Tuition or medial gifts

Grandparents can directly pay a grandchild's college or medical provider

without the payment being subject to gift tax, even for payments above $10,000.

They also may want to consider contributing to prepaid tuition plans or

college savings plans, although the payments may be subject to gift tax.

Roth IRA

If the child earns income, you could contribute your gift to a Roth

IRA in the minor's name up to the amount of income earned or $2,000 annually,

whichever is lower. The Roth later can be used for college or for the child's

retirement.

This column is based on information provided by the Financial Planning

Association, the membership organization for the financial planning community,

and Dennis Filangeri, a certified financial planner in Metairie, La.

—Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer

based in Silver Spring, Md. He specializes in taxes, investing, business

and government workplace issues. He is a certified internal auditor and

a registered investment adviser. He can be reached at miltzall@starpower.net.