When parents and grandparents (or other generous benefactors) want to transfer wealth to a minor child, the primary decision they will face is whether to set up a Section 529 Plan, a custodial account under the Uniform Transfers to Minors Act (an UTMA account) or a trust for such child. Given certain limitations of 529 Plans and UTMA accounts, trusts may be the more attractive vehicle for gifting to minors. This alert briefly summarizes the characteristics of each of the above-described gifting vehicles and explains why trusts may better accomplish a donor’s goals.
Section 529 Plans
Section 529 Plans are a tax-advantaged way to finance the costs of education, in that money contributed to and invested in such Plans grows tax free, and withdrawals for “qualified” expenses (meaning expenses of tuition, room and board, books, and fees for college or graduate or vocational school) are free from federal income tax. In addition, under the new Tax Cuts and Jobs Act, an annual withdrawal of up to $10,000 is permitted for tuition for K-12 schools. Although you can “front load” your contributions to a 529 Plan by making five years’ worth of annual exclusion gifts in one year (which means in 2018 you can contribute $75,000, or, with your spouse, $150,000), the funds can be used only for qualified education expenses. Therefore, if in the future the child needs the funds for other purposes, or if you overfunded the Plan so that less than all of the Plan’s assets are needed for qualified education expenses, the funds cannot be utilized for another purpose without suffering a 10% penalty and the imposition of income tax on the account’s earnings. Additionally, the investment options within the Plan are limited to only those investments that the Plan provides. As of late, 529 Plans have lost much of their appeal since the investment performance of many Plans’ investment options have been disappointing.
Many people find an UTMA account to be an easy way to give property to a minor child. The custodian may use the account to benefit the child in any way he or she sees fit (the assets in the account do not have to be used for only one purpose, such as education), and the custodian has full flexibility over how the account’s assets should be invested. In addition, UTMA accounts are relatively easy to set up. A major drawback, however, is that over time, the value of a child’s UTMA account could be quite substantial, and upon attaining age 21, the child would have full control and authority over the account. The assets in the child’s account would not be protected from creditors, and could limit certain planning options that otherwise would be available should the child subsequently, for example, be diagnosed as having special needs, or develop a drug or alcohol dependency. In addition, most donors who create UTMA accounts for their children name themselves as the custodians of the accounts, not realizing that by doing so, they have not removed the assets contributed to the UTMA accounts from their gross estate. Donors are often hard-pressed to find another individual whom they trust to name as custodian of such an account.
Similar to 529 Plans and UTMA accounts, donors can make annual exclusion gifts to trusts. Unlike a 529 Plan, the assets in the trust can be used for the benefit of the child for whom the trust was created for much broader purposes, and unlike an UTMA account, the trust can be structured to last for the child’s lifetime, or until whatever age the donor prefers (preferably one that is older than 21, when the child might be more responsible and financially savvy). In addition, so long as assets are held in the trust for the child, they should be protected from most creditors, and unlike with a 529 Plan, the trustees of the trust would have a wide range of investment options for the trust’s assets.
Possible trust options as vehicles for annual exclusion gifts include:
Crummey Trusts: Crummey Trusts can be established for one or more beneficiaries of any age, and can last however long you set forth in the trust instrument. Each beneficiary must have a temporary right to withdraw a certain amount of each contribution made to the trust in order to qualify the contribution for the annual exclusion, and therefore must be issued a “Crummey” letter (notice of temporary right of withdrawal) each time a transfer is made to the trust.
2503(c) Trusts: This trust can be established only for a minor, can have only one beneficiary and does not require annual “Crummey” letters. When the minor child attains age 21, the trust must either terminate or provide the beneficiary with a temporary opportunity to withdraw all the trust assets. If the beneficiary does not exercise this right to withdraw, the trust may continue for however long the trust instrument states. The trust can be as flexible as you want.
2642(c) Trusts: Grandparents who would like to make gifts to a trust for their grandchildren, without having to use any of their exemption from the generation-skipping transfer tax, can make annual exclusion gifts to a 2642(c) trust. Similar to a 2503(c) trust, this trust must be for the benefit of only one beneficiary, and the trust assets must be includible in the grandchild’s estate.