Leaving Inheritances Your Way: Why Grandkids Make Things Tricky

When planning to allocate wealth to future generations, one of the main concerns that arises is the prospect of tax consequences not only for the benefactor, but the recipients of the inheritance. While the various methods of spreading inheritable assets – such as through gifting, custodial accounts, trusts, savings bonds and educational or medical donations – should necessitate serious consideration, planning involves much more than simply deciding on the vehicle of distribution. Of particular concern, gifting beyond a single generation becomes complicated.

Why Gifting To Grandchildren Is Different Than Gifting To Children

Due to the generation skip between grandparents and grandchildren, inheritances are treated differently for these situations. Whether the inherited property is directly bequeathed to the grandchild or the grandchild is a recipient of the property following a parent's death, property that is passed down from a grandparent to a grandchild can come with additional tax burdens. One of the more common examples of these tax burdens is the Generation-Skipping Transfer (GST) tax, which is in place to ensure that transfer of wealth to second-generation recipients is not completed to evade taxes.

As Tisa Silver of Investopedia explained, “It [the GST tax] was created to make sure that no one could skip over a generation in order to skip out on taxes.”

A final note from Fidelity Brokerage Services regarding GST taxes: “The tax is only due when a skip person receives amounts in excess of the GST estate tax credit. Fortunately, most people will never encounter the GST tax because the tax credit levels are relatively high.” For 2014, the tax credit level was $5.35 million, with the tax rate for those above $5.35 million at 40 percent.

Related Link: When To Talk With Your Kids About Finances

Something To Keep In Mind

Like most things financial, the inheritance picture becomes clearer as more information is parsed out. Leaving inheritance property does not need to be intimidating, but does require some serious research and preparation. Understanding the different options is the most efficient way to provide for future generations without burdening them unnecessarily.

Just as there is no one-size-fits-all retirement plan, certain inheritance vehicles may be more appropriate than others, depending on the specific situation. In other words, do not assume that gifting the maximum amount each year to individual recipients during the benefactor's lifetime is the best way to spread familial wealth; do not assume that a single estate with numerous beneficiaries is the best, or that custodial trusts for each descendant beats all other options across the board.

Possible Options For Transferring Familial Wealth With Minimal Tax Consequences

Gifting: Outright gifting is an option that may be quite appealing during the lifetime of the benefactor. Gifting not only reduces estate size (and thus the taxes due following death), it is not typically considered taxable income for the recipient. For 2014, an annual gift of $14,000 can be provided to individuals without having to report the gift.

Paying For Education: Whether through a 529 account or paid directly to an educational institution, grandparents can distribute their wealth by providing the financial means for educational purposes.

Paying For Medical Care: Similar to paying to education, grandparents can pay for grandchildren's medical expenses without tax consequences when paid directly to the health/medical institution.

Custodial Accounts: Setting up custodial accounts for minor descendants provides a savings vehicle with adult-managed investing. The contents of the account are limited to mutual funds, or similar products and are not accessible until the minor reaches the state-determined age.

Trusts: Probably the most popular method of transferring wealth from grandparent to second-generation descendants is through a trust. Specific “generation-skipping transfer” trusts can be established to “allow trust assets to be distributed to non-spouse beneficiaries two or more generations younger than the donor without incurring GST tax,” says Fidelity Brokerage Services. These “dynasty” trusts eliminate estate and gift tax burdens for the recipient.

Retirement Plan Recipients: While spouses have the option to roll retirement plan assets from a deceased partner's account into their own retirement savings vehicle, other descendants do not have this option. Children and grandchildren who are recipients of retirement-specific inheritance typically will incur any associated income taxes and be required to take out minimum annual distributions. In order to ensure retirement assets are distributed as wished, beneficiaries should be clearly named on the account documents and specific requests outlined in detail.

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In order to make sure familial wealth is distributed ideally, the benefactor should take the time to plan specifically how he or she would like their assets to be divided among the descendants. With proper preparation and precise directions, inheritances can be left efficiently without unnecessary tax burdens.