We all want to leave our kids a legacy — and if you’re a grandparent who’s built some wealth over the course of your lifetime, an amazing way to build upon that legacy is to gift some of your wealth to your family’s next generation.
By giving money to your grandchildren, you’ll be able to open up all sorts of doors and create new opportunities for them to chase their dreams. But you also need to tread carefully here.
There are rules on how much money you’re allowed to gift to grandkids tax-free. Likewise, you’re going to have a few different investment vehicles available to you as a way to gift money — but some are better than others.
This guide explains how much a grandparent can gift to a child, the best way to give money to a grandchild, and why you should consider gifting money to a child through a UGMA custodial account.
How Much Can a Grandparent Give to a Grandchild Tax-Free?
It only makes sense that you’d want to pass on some of the generational wealth you’ve built to give your grandkids the gift of financial freedom. But before you do, you should be aware of how the IRS may or may not tax those gifts.
If you want to gift money to a grandchild, you’ll be delighted to know it’s possible to transfer cash or other assets over to a child without having to pay taxes on those transfers — but only up to a certain amount.
The Internal Revenue Service (IRS) imposes a cap on the amount of money that you’re allowed to gift to somebody without having to pay tax on that gift. This cap is called the IRS Gift Tax exemption. You’ll also hear people refer to the Gift Tax exemption as the “Gift Tax limit” — but both terms mean the same thing.
The IRS Gift Tax was introduced by the US Government a long time ago to prevent individuals from avoiding paying the estate tax by gifting all of their assets away before they die. Now, the IRS taxes all monetary gifts worth more than the Gift Tax exemption.
There are two different types of Gift Tax exemptions: the annual Gift Tax exemption and the lifetime Gift Tax exemption.
In 2022, the annual IRS gift tax limit is $16,000 per person per year. That means you could gift up to $16,000 to five different grandchildren in a single year without having to even report it on your taxes.
This works similarly if you’re married. If you and your spouse jointly file your taxes, you can gift up to $32,000 per year. That means you and your spouse could theoretically gift $32,000 to each of your grandchildren, another $32,000 to each of your children, and $32,000 to all of your nieces and nephews in one year without having to pay the Gift Tax — or even report the gifts.
In addition to your annual limit, you also have a lifetime exemption of $12.06 million. Every time you go above your annual Gift Tax limit, the excess amount you’ve given will start to get tallied up against your lifetime exemption. If you go above your lifetime exemption, you’ll need to start paying taxes on future gifts to grandchildren.
What is the Best Way to Give Money to a Grandchild?
As a grandparent, it’s important that you understand all of the tax implications of your monetary gifts to grandchildren before you pass on your wealth. But it’s also vital that you have a firm grasp of all the options available to you regarding how you pass on that wealth.
There is a wide range of investment vehicles that you can use to gift money to grandchildren — but each option inevitably comes with its own advantages and disadvantages. To help you get started, let’s break down a few of the most common vehicles grandparents use to give money to their grandkids.
UGMA custodial account
A UGMA custodial account is one of the most flexible and simple ways that you can gift money to grandchildren.
A custodial account is an investment vehicle that an adult can set up for a child beneficiary. When an adult creates a custodial account, they serve as the account’s custodian until the account beneficiary reaches the age of majority, which is either 18 or 21 depending on the state.
That means you’ll make management decisions about the account until the child is old enough to take responsibility for their assets. But even though the child can’t manage the account’s assets, everything in a UGMA account is the legal property of that child.
This is also a major benefit from a tax point of view. Because everything in a custodial account belongs to its child beneficiary, any unearned income generated through compound interest or stock dividends will be taxed at the child’s lower tax rate (up to a certain threshold). This is called the “Kiddie Tax,” and it can noticeably reduce a family’s tax burden.
Custodial accounts don’t have contribution limits, either. This means you’re free to gift as much cash to your grandchildren as you’d like to without getting penalized — you’ll just need to be aware of the Gift Tax limit.
If setting up a UGMA custodial account sounds like an avenue you’d like to explore, you should definitely check out EarlyBird.
EarlyBird’s easy-to-use app makes setting up a UGMA account fast and simple. And unlike other custodial account providers, EarlyBird also enables multiple family members to contribute to the same child’s account in just a few swipes. That can help build a pretty sizable nest egg long before your grandkids ever need it.
The adult setting up an EarlyBird account can choose from a range of portfolios that match their investment style and risk appetite.
Plus, EarlyBird enables you to create a personalized video to accompany financial gifts.
Finally, a grandparent can gift money to a grandchild through EarlyBird even if they don’t have an account yet. That means if the child’s parents would like to set up the investment account but just haven’t gotten around to it yet, gifting through EarlyBird can give them a proactive nudge in the right direction.
It’s also possible for grandparents to give money to grandchildren through a trust fund. If you’re unfamiliar with trust funds, they’re essentially just estate planning tools that create a legal entity to hold on to money or assets for a person until certain conditions are met. Once those conditions are met, the assets are then passed on to a beneficiary.
Families tend to use trust funds to protect the total value of their estate by reducing the inheritance tax for beneficiaries.
The key benefit you get with a trust fund is that you can set rules of whether your beneficiary can or can’t use the funds during a certain age. That means you can set up a trust dictating that your grandkids don’t get the money you’ve saved for them until they turn 30 or that it can only be used to pay for college costs or student loans.
This really places you in the driver’s seat in terms of deciding when, where, and how your grandkids will be able to use a financial gift.
That being said, there are a couple of drawbacks to using a trust fund to gift money.
First and foremost, setting up a trust is complicated and can be expensive. You’ll generally need to get a lawyer involved, and then you’ll have to set up a legal entity and appoint trustees to oversee it. There are also usually management or maintenance fees involved.
Another drawback you should be aware of is that your grandchildren will still likely need to pay a capital gains tax on anything they profit from within the trust.
You can also use a 529 college savings plan to gift money to a grandchild as part of a wider education fund that can only be used for educational expenses, like college tuition.
A 529 plan is a tax-beneficial investment account designed to help families save money for a child’s future educational expenses. When you set up a 529 plan for a child, all the cash you invest in that account is allowed to grow free of federal taxes.
At the point of withdrawal, you won’t get taxed on any of that money, either — but only as long as the cash is being used to pay for a “qualified education expense.”
If you or your grandkids try to use money from a 529 plan to pay for something else (like a car to get to school or off-campus accommodation), the withdrawal becomes taxable. You’ll also normally have to pay a 10% penalty — which is one reason a lot of families choose to set up a UGMA custodial account alongside a 529 plan. 529 plans are generally quite restrictive regarding how you can use your investments.
Likewise, if you gift money to grandchildren through a 529 plan and they decide not to get a college education, you’ll end up having to pay taxes on everything in the account and pay a penalty.
As a grandparent, you want to leave a financial legacy behind for your grandchildren by passing on generational wealth, setting them up for success in life. But before you start gifting money, it’s critical that you understand the tax implications of those cash gifts — as well as the range of investment vehicles available to you.
There are plenty of options out there. But if you’re looking for a flexible and tax-efficient way to give money to grandchildren, one of your best bets is going to be to gift through a UGMA account provider like EarlyBird.
Ready to start giving money to grandchildren and helping develop their financial habits? Download the EarlyBird app now.
This page contains general information and does not contain financial advice. All investments involve risk. Any hypothetical performance shown is for illustrative purposes only. Actual investment performance may be different for many reasons, including, but not limited to, market fluctuations, time horizon, taxes, and fees. Please consult a qualified financial advisor and/or tax professional for investment guidance.