By Steven Brettholtz, CPA, CFF
After the photos are shared on social media and graduation parties are over, reality sets in for many young adults and their parents. Gaining financial independence can be a herculean task for many young adults fresh out of high school or college. Many parents find themselves supporting their adult children in some way, at least for a few years. Some parents allow an adult child, and perhaps grandchildren, to live in at home, some pay bills, and some providing a stipend to cover expenses.
Usually, when clients in this situation come to us, they have questions about the tax implications of supporting their adult children. The good news is rarely will a client confront issues with the gift tax. However, there are other tax and financial considerations worth noting before opening your checkbook.
What is the Gift Tax and Who Pays It?
For most people, the gift tax is a non-issue because you may gift another person up to $15,000 in cash or assets in any one calendar year. If you are married, your spouse can also gift an equal amount to the same person. So, a married couple can conceivably provide their adult child up to $30,000 of support in a year without triggering any action related to taxes.
However, if you cover a major expense—such as a new car, a down-payment on a house, or a dream honeymoon for a wedding present—it is conceivable you will cross the annual exclusion threshold, particularly if you aren’t married. What happens then? Not much. You simply need to submit IRS Form 709 to report the gift to the IRS. Even if you need to file Form 709, it’s still unlikely you or your child will need to pay a gift tax on the money or assets.
The IRS uses the information reported on Form 709 to track how much beyond the gift tax exclusion you give to another individual. There is a lifetime maximum tax exclusion of $11.4 million. So, if over your lifetime you end up going over the annual exclusion threshold (set at $15,000 for 2019) to a tune of more than $11.4 million, the amount you exceed by is subject to a gift tax. The tax rate varies but can be as high as 40% and is paid by the giver, not the recipient. However, this amount in excess of your annual exclusion will continue to accrue each year you go over the IRS’s excludable amount and can potentially affect the tax-excluded amount your child inherits from you upon your death.
Other Gift Tax Imperatives
More good news, money paid for tuition, medical expenses or health insurance premiums paid on behalf of your adult child are not counted as gifts and need not be reported, no matter how much the bills add up to. Although you must pay the school, hospital or insurance organization directly.
Interest-free loans, on the other hand, are considered a gift by the IRS. If you are thinking about supporting your son’s new enterprise with a hefty loan, consider drawing up a loan agreement using the IRS’s Applicable Federal Rate. It’s a much lower interest rate than a bank loan and will free you from worries about the gift tax. It also allows you to potentially deduct the money as a loss if the money is never repaid.
A word of warning about allowing your adult child access to your bank account. It may seem expedient to make your adult child a signer on a bank account you own. After all, then they can pay their bills without having to bother you to write a check or transfer money. However, by giving them free access to the account, the IRS can consider the entire balance of the account a gift and trigger the reporting requirement. It also makes account vulnerable to your child’s creditors and future child support or alimony claims.
One last potential gift tax pitfall is penalties for failure to report. Even if you won’t owe any tax, you must still file Form 709 for amounts in excess of the excludable amount. Interest and penalties for failure to file will go back to the date the gift was made, leaving you with a hefty penalty even if you own no taxes on the gift.
Can My Adult Child Be a Dependent?
An adult child qualifies as a dependent and can be claimed on your taxes if they are 19-24 years old and a full-time student for at least 5 months of the year and resided with you for more than half the year. They can be any age and considered a dependent if they are totally and permanently disabled. To be your dependent, the child must not be claimed as a dependent on someone else’s taxes and you must provide more than half his or her support during the tax year.
However, even if your child isn’t a full time student or has passed the age of 24, your adult child may still be considered a dependent. They would be a “qualifying relative” and can be considered a dependent if they have no more than $4,150 in gross income (for 2019) and you are providing more than half their support during the year. They do not have to live with you to be considered a dependent.
You can spend any amount on a dependent without the money being counted as a gift, so the gift tax rules will be irrelevant if your child is considered your dependent, regardless of how old he or she is.
Placing Limits on Support
The greatest issue clients face when supporting adult children is not the gift tax, family loans, or determining dependency status. It is most often jeopardizing their retirement.
For example, according to the Consumer Financial Protection Bureau (CFPB), the number of consumers over the age of 60 with outstanding student loan debt quadrupled from 2005 to 2015. A 2017 report from CFPB found that 40% of those over age 65 carrying student loan debt defaulted on those outstanding loans. Many of these older adults struggling to repay loans are actual parents who co-signed their children’s students loans, which their children are able to repay.
Other parents have made early withdrawals from the retirement savings to help adult children pay debts or avoid financial hardship. Not only does this affect the parent’s ability to retire, but it triggers a 10% penalty tax on top of being taxed on the withdrawn amount as gross income.
Our advice for any parent confronting the need to assist an adult child is to familiarize yourself with the possible issues, scenarios and financial implication—including taxes—before making an open-ended commitment. A little forethought at the outset and a few open conversations about limits and planning can create a positive outcome for both the adult child and the parents.
Steven Brettholtz is president of Myers, Brettholtz & Company, PA. His decades of accounting experience include numerous assignments in all phases of taxation for individuals, businesses entities and non-profit organizations. He is a member of the Florida, California, Hawaii, Nevada, New York Accountancy Societies, and the American Institute of Certified Public Accountants (AICPA).