Any small child would be thrilled to get a crisp $20 bill for the holidays. But at this time of year, many parents and grandparents have something bigger in mind: a sum big enough to make a real difference to a child or adult, perhaps for a life-changing purpose, like college or a home down payment.
And in some cases the giver is trying to benefit as well, by avoiding taxes on a block of stock, for instance, or by reducing a future estate-tax bill.
But when serious money is involved, the giver needs to burrow into the tax laws to be sure the gift won't trigger a tax bill that could be avoided. And there are issues of control if you worry the recipient might misuse your gift.
"This can be a bad thing if you don't want little Jane or Johnny to decide at 18 they would rather use that money to buy a motorcycle and travel with their new love interest, checking out which state has the best drugs," says Steven J. Weil, president of RMS Accounting in Fort Lauderdale, Florida.
Fortunately, if you've dug into gifting issues in previous years, the key rules haven't changed this year. In fact, people of ordinary means generally don't face tax issues with gifts. That's because the law allows an individual to give someone up to $14,000 a year with no tax for giver or recipient. A couple could therefore give $28,000 to each child or grandchild with no tax implications.
Bigger gifts get one into the realm of the lifetime gift credit. Basically, large gifts reduce the portion of the giver's estate that is exempt from estate tax. But since that exemption is very large — $5,430,000 in 2015 — only the wealthy need worry about this. An annual gift larger than $14,000 per individual is reported in the tax return on Form 709.
Regardless of whether there is a tax issue, many givers want some control over how the money is used. For a child under 18 or 21, depending on the state, the easiest option is to set up a custodial account controlled by an adult. That can be the giver, a parent or someone else. Once the child hits the state's age of majority, he or she will get control of the funds. Depending on the state, custodial accounts fall under the Uniform Gift to Minors Act or Uniform Transfer to Minors Act. Any bank, brokerage or mutual fund company can set up an account.
For greater control, the giver can establish one of various types of an irrevocable trust, which allows someone other than the recipient to control the funds even after the recipient becomes an adult. Irrevocable means the funds must be used for the recipient's benefit and cannot be taken back. Generally, a trust is set up by a lawyer.
"Money may be gifted for someone's benefit without actually giving them access to the money," says Michael Fuhr of SageVest Wealth Management in McLean, Virginia. "The trust can be created for many different situations, such as protecting the trust assets from spouses, creditors or even the beneficiary themselves."
Lisa Hutter, regional wealth-planning manager for Wells Fargo Private Bank, said, for instance, that it can be wise to set up a trust for a married child in that child's name only, to help protect the assets in a divorce.
In many cases, the giver wants to help with a college education. Trusts are useful for this, but a simpler option is the Section 529 plan, a state-authorized account set up at a bank, brokerage or mutual fund company for funding education. The big advantage: Investment gains are free of federal tax, and in some cases state tax, when used for approved purposes like tuition, books, a computer and room and board.
In fact, you can make five years' worth of $14,000 gifts to an individual at one time without triggering gift-tax issues. That would allow more time for tax-free growth before the money is used.
Many 529s make investing decisions easy by offering "target-date" options that emphasize stocks when the child is young, hoping for big gains, then gradually shift to safe bonds and cash as the college years approach. Note there are big penalties and taxes if the fund is withdrawn for an unauthorized purpose, though there is some leniency if, for example, the beneficiary gets a scholarship.
If the college years have started, or are about to, payments made directly to the college, even if larger than $14,000 a year, are free of gift tax. (The same rule applies to medical expenses paid directly to the provider.)
A down payment for a home is another common reason for a sizable gift. The $14,000 rules apply, and there is no gift-tax exemption for larger sums, but the bigger issue is how the gift will affect the recipient's mortgage application. Lenders want to be sure the sum is really a gift and not an informal loan. Too much debt, they reason, increases the risk of default.
"Lenders are asking more questions than ever," Weil said. "Best bet," he added, "is to set up an account and make the gift early — as much as a year before you start the purchase process. It's also helpful to file the proper gift-tax returns, which prove it was reported to the IRS as a gift."
In some cases, a parent or grandparent wants to use a block of stock or other asset for the gift, raising the question: Should I sell it and give cash or just give the security itself?
Giving the security can make sense if more gains are expected, and this option can allow the giver to avoid taxes on past gains. But there's no free lunch — the tax obligation is shifted to the recipient. If you bought a block of stock for $5,000 10 years ago and it's now worth $10,000, the "cost basis," or original price paid, is passed on to the recipient. After selling the security, the recipient will pay tax on all gains above the giver's tax basis.
So deciding whether to give the stock or sell it and give the cash depends on the tax situations of both giver and recipient. Long-term capital gains tax rates range from 0 percent to 20 percent, depending on the taxpayers income-tax bracket. Generally, it would make sense for the person in the lower tax bracket — giver or recipient — to take on the tax obligation. If the gift is large and has a lot of investment gains, it may pay to get an accountant's opinion.
But if the gift involves a money-losing investment, experts generally recommend selling it and giving the cash. That way, the giver gets to claim a tax loss.
As you can gather, the basics covered here are, well, just the basics. The larger the sum involved and the more complex the situation, the more likely you could benefit from a tax, estate or trust lawyer, or an accountant or investment adviser.
— By Jeff Brown, special to CNBC.com