Q. As a holiday present, I’m thinking of opening an IRA for each of my three grandchildren. But they don’t have real income yet. Does that mean an IRA is out of the question? What are my options?
A. Your grandchildren are fortunate that you would like to help them save for the future. You have options, but an IRA may not be one of them. In order to contribute to an IRA, the participant must have earned income that consists of wages, commissions or self-employment income, said Claudia Mott, a certified financial planner with Epona Financial Solutions in Basking Ridge.
“The amount that you would be able to contribute would be the lesser of $5,500 or the total amount they earned,” she said. “But without income, you won’t be able to open the IRA account and fund it for them.”
You do have alternatives.
First, a Uniform Gift/Transfer to Minors Act account. Known as UGMAs and UTMAs, these accounts are set up on behalf of a minor beneficiary by an adult account owner, Mott said. “The owner has oversight for the account until the beneficiary reaches the age of majority which is typically 18 or 21,” she said. “Both accounts are held at a custodian such as a bank or investment firm and can receive contributions from family and friends at any time.” Mott said an UTMA allows almost any type of asset to be transferred to it including real estate, securities such as stocks, bonds and mutual funds and cash.
The UGMA, in comparison, is limited to bank deposits, insurance policies and securities. “The annual gifting exclusion that would prevent the donor from needing to file a tax return is $14,000 per donor for each recipient,” Mott said. “A husband and wife could each gift $14,000 to a child or grandchild.” That amount moves up to $15,000 in 2018.
The tax implications of these accounts can be unfavorable if the accounts grow too big, Mott said.
“Unearned income such as interest, dividends and capital gains are exempt from tax up to $1,050,” Mott said. “Beyond that they are taxed at the child’s rate and eventually the parent’s rate if there is more than $2,100 in unearned income.” Mott said it’s important to discuss how much you may plan on putting into these accounts with your tax professional in order to understand the potential tax issues.
You could also consider a 529 plan.
“A 529 or qualified tuition program allows earnings to accumulate on a tax-deferred basis,” Mott said. “Distributions that are used for qualified education expenses such as tuition, room and board are tax and penalty-free.” Because contributions are considered a gift, the annual exclusion of $14,000 should be considered to avoid the need to file a gift tax return, Mott said, and a lump sum of $70,000 covering a five-year donation period can also be made. The ownership of a 529 plan is important. A grandparent-owned 529 account is not reportable on the student’s FAFSA, which is good for aid eligibility. But, Mott said, any distributions to the student or to the student’s school from a grandparent-owned 529 must be added to student income on the following year’s FAFSA, which may limit the amount of aid granted. “One way to avoid this problem is to hold off using money from a grandparent-owned 529 until after Jan. 1 of the student’s junior year,” she said. “The other option is to have the parent set up the 529 and you gift the money to fund the account.”
Let’s not forget the Coverdell Education Savings Account (ESA), which was commonly called an Education IRA.
A Coverdell ESA can be set up at a bank or brokerage firm to help pay the qualified education expenses of your grandchild, Mott said. “These accounts allow money to grow tax-deferred and withdrawals are tax-free at the federal level — and in most cases the state level — when used for qualifying education expenses,” Mott said. “Coverdell benefits apply to higher education expenses, as well as elementary and secondary education expenses.” Mott said Coverdell contributions are not deductible, and contributions must be made before the beneficiary reaches age 18 unless he or she is a special needs beneficiary as defined by the IRS.
“While more than one Coverdell can be set up for a single beneficiary, the maximum contribution per beneficiary per year is limited to $2,000,” she said. “To contribute to a Coverdell, your modified adjusted gross income must be less than $110,000 as a single filer or $220,000 as a married couple filing jointly.” With both the 529 and the Coverdell account the money can be withdrawn in the event the child does not attend college, there will be tax and a 10 percent penalty on the earnings.
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