Parents have asked me many times over the years about setting up bank accounts for their kids and setting money aside for them for their future. Their goal, of course, is to create a pot of gold for hard times, something their kid or grandkid can rely on when the going gets tough.
What a nice thing to do, right?Wrong. If I had a buzzer, I’d use it. There are few hard and fast rules in estate planning, but this is one. Never, ever allow a child to own assets or be a direct beneficiary of anything. Ever.
How could you know that if you put money into a bank account, you lose all control over that on your child’s 18th birthday (in some states 21st birthday)? First, you’d have to know that these accounts are called custodial accounts. They’re also known as UTMA accounts, which stands for “Uniform Transfers to Minors Act.” Sometimes, people refer to it as “Uniform Gifts to Minors Act” or UGMA.
These are accounts owned by the child, but are taken care of by an adult custodian. The custodian has absolutely no legal ownership over the assets at all, they’re just taking care of it until a child reaches 18 when the child can take over. The key point is that the child owns the money personally.
Imagine this. Grandma and Grandpa are loaded. They’ve been saving all their lives and are just tickled to be able to leave a very valuable legacy behind. Their estate planner has told them to gift assets out of their estate every year using the $14,000 annual unlimited gift tax exclusion amount to reduce their taxable estate or simply to be kind. They think, “Great! I can help out my kids by setting aside money for my grandchildren’s education, first wedding, or first business, or whatever.”
They open up an account for each of their grandchildren and put $14,000 in each account for 18 years. That’s $252,000 in contributions. When you add compound interest and adjusted for inflation, your child could end up with as much as $553,000 at 5% interest, more if average return is higher. Wow! I’d love to have been that grandchild!
That’s a LOT of money to be receiving at age 18, isn’t it? And guess what? If it’s in any kind of account under the child’s name with a custodian, you as the parent can’t do anything to prevent your child from taking title to that asset on their 18th birthday. Not. One. Thing. Remember, your child is the owner of a custodial account.
Here’s the problem. Children are under the legal “disability” of minority until they reach 18 when suddenly, Abracadabra! they aren’t legally disabled anymore. Because the child owns the account, you have no choice but to turn the account over when the child is no longer legally disabled.
In the meantime, your job is to manage that money better than you manage your own. That means if you mess up and lose it, your child can sue you later on for breach of fiduciary duty. If you put that money in a family business that goes belly up, you’re liable for that loss. If you invest in a stock that goes bankrupt, you’re responsible to your child. Even if you were the one who gave them the money in the first place.
I know, right?!
Why on earth, then would you allow yourself to be at risk of a lawsuit from your own child for a gift you or your parents gave them, when there is a much better way to give to your children?
Here’s the right way to do it:
Set up an irrevocable trust with you as your child’s trustee. Make sure it’s a lifetime asset protection trust and provides for use, enjoyment, and/or distribution according to a schedule and terms that you decide well in advance.
Let’s call this trust a “Gifting Trust”. Your child’s trust can be funded by gifts from you or your parents, or anyone who would like to make a gift to them. It can be made to be “intentionally defective” for the purposes of income tax so that you can pay the income tax at your rate (or your child’s when they’re adults), not at a trust rate, which is much less burdensome.
The principal and income can be invested or used for your child’s “health, education, maintenance and support.” These are standards that help protect the assets from your child’s creditors in the future. When you die or are incapacitated, you will have named a successor trustee of your choice.
Because of the rules you put into the trust agreement allowing you to invest aggressively, you are at much less risk of a lawsuit from your child because their interest is not as an owner, but as a beneficiary. You still have to do a decent job of managing it, but you will have made sure that the trust absolves you from investment mistakes that are made in good faith.
You can choose to allow your child to become their own trustee at some far distant point in the future—like when their in their 30s. Or you can decide someone else will always be their trustee. Either way, you’ve just avoided entirely the problem of making a child an owner of things they’re not allowed to manage.
The Gifting Trust is a much better way to gift. If you or your parents are committed to creating a pot of gold for your kids or grandkids, see an estate planning attorney who’s familiar with the best practices for trusts, kids, and money.