Aside from a last will and testament or a trust, there are several ways to effectively transfer your wealth to your grandkids.

The tax laws affecting estate planning have changed and created unique opportunities, but many of the provisions may expire in 2025. With the newly increased gift tax exemption, and the doubling of the generation-skipping transfer (GST) tax exemption, a historically high value of assets can be transferred tax free, and sheltered from estate tax in the future.

Creating a legacy plan involves a transfer of assets and this almost always comes with tax consequences. Remember the gift tax still exists, and depending how much you gift to a grandchild, you may also trigger the “Kiddie Tax.” Prior to the Tax Cuts and Jobs Act, all but a small portion of a child’s unearned income would be taxed at the parents’ marginal rate, but the new law now taxes a child’s unearned income (capital gains, dividends and interest) according to the tax brackets used for trusts and estates, which are taxed at the highest marginal rate — 37%.

So, what are the other attractive alternatives? IRAs, Insurance, and 529 Savings Plans.

Using an IRA to transfer wealth to your grandchildren

An IRA is a valuable vehicle with which to build a nest egg. With years and years of tax-advantaged, compounded growth, often there will still be money in the account when the owner dies. That money, when passed to heirs, can continue to grow in an IRA, potentially for decades into the future. Heirs who are spouses vs those that are non-spouses like grandchildren have different sets of rules, so it best to understand the rules and the deadlines that must be met when the money is received in order to “stretch the account” for years to come.

If you wish to leave money from your IRA to your grandchildren you have a few options:

  • You can name your spouse as the primary beneficiary and then the grandchildren as contingent beneficiaries. They will inherit what is left at the death of your spouse.
  • You can name your grandchildren as the primary beneficiaries.
  • Note that naming an estate or a trust as a beneficiary may affect the ability of the grandchild to “stretch” the inherited IRA over their own lifetimes, and the tax shelter is lost.

When a grandchild inherits, the following rules apply:

  • The grandchild must rename the account to include both the beneficiary’s name and the decedent’s name, for example “Mary Smith (deceased March 1, 2018) for the benefit of Joe Smith.”
  • A non-spouse heir can’t roll the money into their own account, nor can they convert inherited traditional IRA money to a Roth IRA. If you want your non-spouse heirs to have Roth money, you must convert the accounts before you die.
  • To stretch an IRA over the grandchild’s lifetime, Required Minimum Distributions (RMD) must be taken by December 31 each year, starting in the year after the original owner died.
  • The beneficiaries won’t pay an early-withdrawal penalty on the distributions. They will pay income tax on RMDs from inherited traditional IRAs, while RMDs from inherited Roth IRAs will be tax-free.
  • If an heir misses that inherited Roth RMD, he will be subject to a 50% penalty on the amount that should have been taken out, and lose decades of tax-free income.

Keep the following in mind:

  • Even if heirs are inheriting taxable distributions, stretching out those distributions is likely more advantageous than cashing out the inherited IRA all at once.
  • If multiple grandchildren are named, each beneficiary can stretch her distributions over their own lifetime. The inherited IRA must be split by December 31 of the year following the year the owner died.
  • If the account isn’t split, the life expectancy of the oldest beneficiary must be used to calculate RMDs. That makes a big difference if the beneficiaries have a wide age gap, because the younger the heir, the smaller the RMDs.
  • Minors cannot inherit an IRA outright. Designate the grandchild as a beneficiary of your IRA and appoint a custodian (like Mom or Dad) to oversee the account if you die before the child reaches adulthood.
  • Some firms will not open IRAs for minors and won’t allow minors to be named as beneficiaries – you may want to make a change because many firms do.
  • If you are worried a young beneficiary will misuse the account, you can arrange for the trust to become the IRA beneficiary and for the minor to become a beneficiary of the trust (however there may be issues with “stretching” the account).

Using insurance to transfer wealth to your grandchildren

You don’t need “millions” to leave something for your grandchildren after you die. The point of life insurance is to make sure those who rely on you financially will be okay. Single premium life insurance is a valuable investment when it comes to wealth creation and transfer. The cash value in a fully funded policy will grow quickly and can provide income to the purchaser if needed. In turn, the purchaser can also surrender the policy for its cash value at any time. Look for a policy that has the option of an accelerated death benefit that can be drawn on to pay for long term care coverage.

A traditional whole life policy has a guaranteed interest rate and is the least aggressive. Universal life has different interest rate structures and can use an equity-index or variable engine to increase the policy value.

Certainly the advantage of life insurance over an annuity, a savings bond, a certificate of deposit or other investment is the favorable tax treatment of a life policy. The entire death benefit is passed income tax free to the beneficiary. However, the death benefit can count toward the gross value of an estate for estate tax purposes. To avoid estate taxes, some policies are owned by the beneficiaries or an irrevocable life insurance trust.

There are two ways to remove a life insurance policy from your taxable estate:

  • The first is to place it in an irrevocable trust. A trustee takes control of the plan and makes sure premiums are paid and money is divided up according to your wishes after you’re gone.
  • The other option is to transfer ownership of the money directly to a grandchild, 18 years old or more. The process usually involves filling out assignment or transfer forms with your insurer.
  • Once you transfer the policy over, you no longer have any control so you can’t change the beneficiaries or increase the coverage limit. If you transfer a policy and die within three years of the transfer date, it’s still considered part of your estate for taxation purposes. If you’re concerned about your health, transfer the policy sooner rather than later to avoid the potential tax implications.
  • If you transfer a cash value life insurance policy to someone and it’s worth more than the exclusion limit, it’s considered a taxable gift.

Using 529 Savings Plans to transfer wealth to your grandchildren

529 Plans are easy to set up to help pay for eligible college expenses, and thanks to Tax Reform, also for tuition for an elementary or secondary public, private or religious school. With 529s, you pay income tax on the money you put into the grandchild’s plan, but there are no taxes paid on the earnings that grow in the account, or when funds are taken out to pay for tuition, or college-related expenses. 529 Plans offer high contribution limits, and there are no income limits for contributing.

How do 529 Plans compare to a trust fund? The disadvantage of a trust fund is the tax impact. Money in 529 accounts grows tax-free, and won’t be taxed if taken out for qualified educational expenses.

529 savings plans also offer estate planning benefits. Contributions to a 529 plan are removed from an individual’s estate and it is permissible to “bunch” up to five years’ worth of annual gift tax exclusions into one year, without triggering gift or GST (Generation Skipping Transfer) taxes, or using any exemptions.

Normally, you can give each recipient an amount up to the annual gift tax exclusion without paying any gift tax. The exclusion for 2019 is $15,000 per recipient ($30,000 for joint gifts). Few people know about a that special rule that allows you to contribute up to five years worth of gifts to a Section 529 plan in just one year. So you can effectively transfer up to $75,000 to your grandchild’s account ($150,000 by a married couple) with zero gift tax liability!

CONTACT US: You have plenty of choices when it comes to transitioning resources to your grandkids to insure their educational requirements are met, and they have the financial support to dream big when it comes to a career. The decision of how to leave money to your grandchildren should not be taken lightly, it requires both proper legal and financial planning to choose the right option and not trigger unintended tax consequences.

At TFGFA we make a commitment to providing clients the right products for their needs, clearly explaining the potential risks and returns, and keeping fees at a minimum. We invest the time to educate clients about all options, work with them on defining their goals, and help them understand the advantages and risks associated different financial products and services. We want you to make informed decisions. Feel free to contact me, Cory Lyon, directly at 561-209-1120, with any questions regarding financial investment strategies. I act as a fiduciary for all my clients.

TFG Financial Advisors, LLC is a registered investment advisor.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities, and past performance is not indicative of future results.  Investments involve risk and are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.