Saving for Grandchildren Tax-Free: Strategies to Avoid Gift Taxes

Helping grandchildren financially can set them up for future success, whether through education savings or general support. However, large gifts may trigger tax implications if not structured properly. Understanding how to give without incurring unnecessary taxes ensures your contributions go further.

There are several ways to provide financial support while staying within legal limits. Tax-advantaged accounts, coordination with family members, and adherence to IRS guidelines can maximize the impact of your generosity.

Gift Tax Thresholds

The IRS allows individuals to give a certain amount each year without triggering federal gift taxes. In 2024, this annual exclusion is $18,000 per recipient. A grandparent can give up to this amount to each grandchild without filing a gift tax return. If both grandparents contribute, they can jointly give $36,000 per grandchild without exceeding the limit.

Gifts exceeding the annual exclusion require filing IRS Form 709. However, this does not mean immediate taxes are due. The excess is applied toward the lifetime gift and estate tax exemption, which is $13.61 million per individual in 2024. Federal gift taxes, which can reach up to 40%, only apply once total lifetime gifts surpass this exemption.

Certain payments are exempt from gift tax rules. Direct payments to educational institutions for tuition or to medical providers for healthcare expenses do not count toward the annual exclusion or lifetime exemption. These payments must be made directly to the institution or provider, not given to the grandchild for reimbursement.

Education-Focused Accounts

Setting aside money for a grandchild’s education can be done in a tax-efficient way through specialized savings accounts. These accounts offer benefits such as tax-free growth or favorable financial aid treatment.

529 Plans

A 529 plan is a tax-advantaged savings account for education expenses. Contributions are made with after-tax dollars, but earnings grow tax-free, and withdrawals remain untaxed if used for qualified education costs, such as tuition, fees, books, and room and board at eligible institutions.

There are two types of 529 plans: prepaid tuition plans and education savings plans. Prepaid tuition plans allow account holders to purchase future tuition at today’s rates, which can be beneficial in states with rising college costs. Education savings plans offer investment options similar to retirement accounts, with funds that can be used at any accredited college or K-12 institution.

Contributions to a 529 plan fall under the annual exclusion limit. However, the IRS allows a special five-year election, enabling individuals to contribute up to five times the annual exclusion amount in a single year without triggering gift taxes. In 2024, this means a grandparent can contribute up to $90,000 per grandchild ($180,000 for a married couple) and spread it over five years for tax purposes. If the contributor passes away before the five years are up, the remaining portion of the contribution is included in their estate.

Coverdell Accounts

A Coverdell Education Savings Account (ESA) is another tax-advantaged option, though it has stricter contribution limits and income restrictions. Contributions are capped at $2,000 per beneficiary per year, and eligibility phases out for single filers with modified adjusted gross income (MAGI) above $110,000 ($220,000 for joint filers).

Like a 529 plan, Coverdell ESAs allow tax-free growth and withdrawals for qualified education expenses. However, they offer more flexibility in how funds are used, covering a broader range of K-12 expenses, including tutoring, computers, and school supplies.

Funds must be used by the time the beneficiary turns 30, or they will be subject to income tax and a 10% penalty on earnings. If the funds are not needed, they can be rolled over to another family member under 30 without tax consequences.

UGMA and UTMA

Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts allow grandparents to transfer assets to a grandchild without setting up a trust. These custodial accounts hold cash, stocks, bonds, or other investments in the child’s name, with a designated custodian managing the funds until the child reaches adulthood—typically 18 or 21, depending on state law.

Unlike 529 plans and Coverdell ESAs, UGMA and UTMA accounts do not have restrictions on how funds are used. Once the child reaches the age of majority, they gain full control and can spend the money as they choose, whether for education, a car, or other personal expenses.

A downside is that these accounts do not offer tax-free growth. Earnings are subject to “kiddie tax” rules, meaning unearned income above $2,600 in 2024 is taxed at the parent’s marginal tax rate. Additionally, because the assets are considered the child’s property, they can negatively impact financial aid eligibility, as they are assessed at a higher rate (20%) in the Free Application for Federal Student Aid (FAFSA) formula compared to parental assets (5.64%).

While UGMA and UTMA accounts provide flexibility, they may not be the best option for those primarily focused on education savings due to their tax treatment and financial aid implications.

Coordination With Family Members

When multiple family members contribute financially to a grandchild’s future, ensuring efforts are well-organized prevents unintended tax consequences and optimizes available benefits. Without coordination, overlapping contributions could unintentionally exceed annual limits or interfere with financial aid calculations.

Tracking total contributions helps avoid surpassing IRS limits. A well-documented plan ensures that no one inadvertently triggers a gift tax filing requirement or depletes their lifetime exemption without realizing it. Families often use shared financial tools, such as a dedicated spreadsheet or a financial advisor, to monitor contributions across multiple donors.

Estate planning tools like irrevocable trusts can also structure financial support efficiently. A grandparent might establish a trust that benefits multiple grandchildren while maintaining control over how the funds are distributed. This can be useful for families who want to ensure money is used for specific purposes beyond education, such as home purchases or entrepreneurial ventures. Trusts can also help shield assets from being counted toward financial aid calculations.

A coordinated approach also extends to investment strategies. If different family members contribute to various financial accounts, aligning investment choices can prevent unnecessary risk exposure or duplication. Reviewing these strategies with a financial professional can help create a balanced approach tailored to the child’s long-term needs.

Handling Large Contributions

Large financial gifts require careful structuring to avoid unintended tax liabilities and ensure efficient wealth transfer. Trusts offer greater control over asset distribution and can provide tax advantages. A grantor-retained annuity trust (GRAT), for example, allows a grandparent to transfer appreciating assets while retaining an annuity payment for a set term. If structured properly, the remaining assets pass to beneficiaries with minimal or no gift tax consequences. Dynasty trusts, which can last for multiple generations, also shield assets from estate and generation-skipping transfer taxes.

Another approach is gifting appreciated securities instead of cash. When an individual donates stock or mutual fund shares that have gained value, the recipient benefits from the full market value, while the donor avoids capital gains tax on the appreciation. This can be especially beneficial for assets with significant unrealized gains. If the beneficiary is in a lower tax bracket, they may also face a reduced capital gains tax rate upon selling the asset. Care must be taken to ensure the recipient’s income level does not trigger the “kiddie tax,” which applies higher tax rates to unearned income above a certain threshold.

Documenting Transactions for Compliance

Proper documentation ensures that financial gifts remain within legal limits and do not trigger unnecessary tax scrutiny. The IRS requires records for any gifts exceeding the annual exclusion, but even smaller contributions should be tracked to maintain transparency. Keeping detailed records of transfers, including dates, amounts, and recipient information, helps substantiate gifts in case of an audit.

For gifts requiring IRS reporting, Form 709 must be accurately completed and filed with the donor’s tax return. If payments are made directly to educational or medical institutions to qualify for the unlimited exclusion, maintaining receipts and proof of payment is necessary. Financial advisors and estate planners can assist in structuring gifts to minimize tax exposure while ensuring all documentation meets IRS requirements.