Giving to Grandkids
A grandparent who has successfully managed a trust for a grandchild might not be comfortable letting some young whippersnapper make the investing decisions. Learning to compromise can be best for family harmony and for the health of the trust. An Education IRA is a wonderful way for grandparents to give their grandchildren a financial boost right when they will likely need it most.
By Barbara Eisner Bayer (TMF Venus) and Ann Coleman (TMF AnnC)
December 12, 2000
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Q. I recently got married (yay!) and my new wife has money in a trust that her grandfather set up and currently administers. He put $5,000 in some mutual funds in 1981, and hasn't touched it since. It's worth approximately $108,000 now. I know you don't like mutual funds, and I feel confident I can put that money to good use picking individual stocks, but there are tax implications -- about $12,000 would be due if we sell it now. Grandfather says let it ride. In the interests of marital (and in-law) harmony, I'm okay with that. We're very grateful to have this -- not many people can set money aside for future generations and not touch it for almost 20 years. But, I shudder to think what that money would be worth if it had been invested, say, in Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> (and its IPO was in 1986, not 1981)! What, like $2 million? What do you think, leave it or withdraw it?
A. Yep, $5,000 invested in Microsoft at the IPO would be worth about $1.8 million, today. (It was worth rather more than that last year, of course!) But, Grandpa hasn't done so bad, you know. His funds have averaged about 16.5% over the last 20 years, and that is after paying at least part of the capital gains taxes. That beats the S&P 500 Index, which has only averaged 15.6% if you include this year's lousy performance with no tax payments included.
Beating the market by one percentage point per year over 20 years is not easy, especially using mutual funds! It's one thing to be confident, but quite another to pick the next Microsoft before the rest of the market notices it.
You don't mention any experience you might have picking stocks, so I'm assuming you are a beginner or close to it. Guess what we suggest for beginners? Mutual funds. Specifically, we suggest index funds, but as long as Granddad's funds are beating the market, I see no reason to switch and pay the taxes. (The biggest issue we have with mutual funds is that so many of them underperform the overall market.)
If you sell now, you cut your principal by $12,000; that's cash that isn't going to be working for you any more. Use our savings calculator to see the long-term effect of reducing your principal by $12,000. You'll need to pick some great stocks to make up for that. While you are there, note that if you get the same rate of return over the next 20 years, that trust will be worth more than $2 million. The next Microsoft might get you there faster, but you can still get there. And, what if you pick the next priceline.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PCLN)") else Response.Write("(Nasdaq: PCLN)") end if %>?
I can think of one good reason to sell some fund shares now -- the Roth IRA. If you qualify, you and your wife together can put $8,000 into a Roth over the next few months -- that's $2,000 apiece for this year and another $2,000 apiece for next year. Putting the money into a Roth effectively exempts it from taxes "forever." In that case, paying capital gains now is a bargain. Of course, if you are already funding a Roth from your regular income, you don't want to stop doing that. And, putting the money in a Roth doesn't address the question of how to invest it.
Let me suggest a compromise. Suggest to Grandpa that you "paper trade" for a year, then compare results. If your picks beat his funds, you get, say, 5% or 10% of the real money to play with. Every year that you beat his funds, you get more of the trust to control. That way, you win either way. You can use our Portfolio feature to set up your paper accounts.
One caveat: suggest the competition only if you think all parties can keep it friendly. It's not worth fighting over.
Q. I would like to invest $1,000 for my one-year-old granddaughter with the idea of letting it grow into a college fund. What do you recommend?
A. Terrific idea. The Education IRA was created to help save for a child's college expenses and can be established for anyone who's under 18 years of age. (I think your granddaughter will qualify.) Even though Educational IRA contributions are limited to $500 per year, those modest deposits have plenty of time to grow.
But, you need to act fast if you want to put that full $1,000 to work tax-free. Education IRAs are not like other IRAs. You don't have until April 15 to make a deposit for this year. The money has to be in the account by December 31. Then, on January 2, you can add the second $500.
It's probably easiest to set up an Education IRA at a bank when time is short. Then next year you can look into transferring it to a brokerage or mutual fund company if you want to go for higher returns than banks offer.
There are some conditions you should be aware of. Contributions may only be made by taxpayers who fall under the limits for adjusted gross income (AGI). A full $500 contribution can be made by single persons with an AGI of $95,000 or less, and joint filers can make the $500 contribution if their AGI is $150,000 or less. As a single filer's income approaches $110,000 (or $160,000 for joint filers), the contribution limit is decreased ratably to zero. Plus, each child is only entitled to one Education IRA. If your income is up there, or if Mom and Dad are already funding an Education IRA, you'll have to investigate other options such as a Uniform Gift to Minors Account.
Whatever account you set up, be sure you understand the advantages and limitations. Our series on Investing for Your Kids is a good place to start. For example, earnings from the Education IRA account are tax-free as long as withdrawals are used for qualified education expenses. But, if you decide to take distributions for purposes other than qualified educational expenses, the earnings (but not the contributions themselves) will be treated as taxable income and might be subject to a 10% penalty. It's best to know these things going in.
Details aside, this is a great idea. You've got a lucky granddaughter.
