College Fund May Prove Taxing for Grandparent’s Estate

Q. I’m interested in giving my grandchildren money for their college educations and am looking into American Century-20th Century Giftrust, which I heard was highly recommended. However, my financial advisor is trying to warn me away from this investment because whatever amount I give the fund would be deducted from my $600,000 estate tax exemption, even if the gift is less than $10,000 per year. Can this possibly be true?

--M.G.

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A. Your advisor is correct: Investments in American Century-20th Century Giftrust, a fund specifically established to accept gifts for youngsters’ college educations--do not qualify for the $10,000-per-year exclusion from the $600,000 lifetime estate-tax exemption allowed every taxpayer. Every time you purchase shares of Giftrust, regardless of the amount, you must file a gift tax return with the Internal Revenue Service, notifying it that you have in essence reduced the amount of the estate-tax exemption your estate is entitled to claim upon your death.

“Unfortunately,” says Tom Lancaster, a retirement plan counselor with Royal Alliance in Lake Forest, “this has become a ‘nasty’ surprise for many folks who have contributed to Giftrust without fully understanding the gift-tax consequences.”

Why is Giftrust, a one-of-a-kind fund, handled this way? Because it is considered a gift of “future interest.”

The IRS considers gifts such as cash, stock, real estate or mutual fund shares as donations of “present interest” because they have a real and immediate value to the recipient. As such, they qualify for the exclusion that allows each taxpayer to give any other individual up to $10,000 per year without lowering his or her $600,000 estate tax exclusion.

But gifts of “future interest” do not qualify for this $10,000 exclusion. Why? Because, generally speaking, “future interest” grants the right to use an asset only in the future.

Here’s where the fine print starts. The fact that an asset such as a bond or insurance policy is payable in the future does not necessarily give it “future interest” status, in large part because recipients of bonds and insurance policies are legally able to cash in those assets at any time, albeit at a healthy discount in most cases.

A Giftrust recipient is prevented from touching any portion of the account until it matures, which occurs when the holder turns 18 or has had the account 10 years, whichever occurs later.

Given that, you might wonder why anyone could recommend Giftrust, let alone why investors have put nearly $900 million into it. The answer is the fund’s historical performance. As of June 17, the fund’s 10-year average annual rate of return was 17.49%, the five-year average was 24.11%, and the three-year average was 18.86%. It’s a track record based on the fund’s aggressive investment strategy. Holdings are almost exclusively in fast-growing small companies, a position stemming from the fund’s precise knowledge of when accounts will mature and withdrawal demands made.

Aggressive investing has its downside, of course, and it’s especially apparent when one or more stocks in a fund’s holdings sour. If you track Giftrust, you’ll see wide fluctuations in value month to month, even day to day. For the last year, the fund’s return is down nearly 15%. But Giftrust investors are there for the long haul; they have to be. So the managers can pursue their strategies without the short-term pressures facing other funds.

Lancaster, for one, isn’t convinced that the fund’s admittedly strong historical performance is worth the estate-tax issues and gift-tax-reporting hassles. Instead, he recommends a fund such as Templeton Growth for clients wanting to help with their grandchildren’s college costs. Another choice, he says, is SteinRoe Young Investor Fund, which typically holds stocks of companies of particular interest to kids, such as as McDonald’s Corp., Coca-Cola Co. and Walt Disney Co.

Many financial planners, though, say that unless these funds are large enough to cover a student’s entire college bill (in effect ruling out the need for aid), any accounts held in a student’s name could well prevent him or her from qualifying for such aid.

Lancaster argues that short of establishing a trust through an attorney, grandparents are most often best served holding on to the money themselves and investing it with the intention of paying the college directly.

Note: A recent column item regarding the waiver of penalties for early withdrawals from tax-sheltered retirement accounts contained an error. The 10% penalty for withdrawals made by taxpayers older than 55 who have been separated from their jobs is waived only for withdrawals made from what the Internal Revenue Service calls “qualified” profit-sharing plans. These include 401(k) plans and many, but not all, 403(b) plans. The penalty is not waived for withdrawals from IRAs, even if the IRA funds were originally transferred there from a 401(k) account.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. Or send e-mail to [email protected]