For decades, parents have used custodial accounts to transfer funds to
their minor children to help build assets for college costs. However the 2001
tax law has enhanced the tax benefits of other types of asset ownership that
should be considered. Education IRAs and Qualified Tuition Programs (Section
529 Plans) have become very attractive.
Custodial Accounts
Using a Uniform Gifts to Minors Act (UGMA) or Uniform Transfer to Minor Act
(UTMA) account is an easy and legal way to transfer the ownership of assets
to a child. With a UGMA or UTMA account, the parent creates a custodial
account on behalf of the minor child. Assets are transferred into the account
and the custodian, usually a parent, manages the account until the child
reaches legal age. At that point, the child can do whatever he or she wishes
with the assets.
Transfers to these accounts are irrevocable. You cannot change your mind
later and take the assets back. Your child becomes the owner when you make
the transfer an on reaching the age of majority (18 or 21 in most states) the
child can do whatever they wish with the money.
Transfers into a custodial account are just like any other gift. You can
make annual gifts up to $11,000 in cash, securities or other property to
anyone without owing any federal gift tax and without filing a gift tax
return. If you are married, gifts can be considered to be half from you and
half from your spouse. This enables transfers up to $22,000 to be made.
However, a simple gift tax return may be required if you use this gift-
splitting technique. The annual $11,000 exclusion applies to each person
receiving the gift.
When the assets become the child's, any income the assets produce is taxed
to the child. The tax laws provide that the first $800 of investment income
from assets held in the child's name is tax free. The next $800 is taxed at
the child's tax rate (usually the lowest rate of 10%). Investment income
greater than $1600 is taxed at the parent's rate until the child reaches age
14. After age 14, the income is taxed at the child's rate.
Education IRAs
Education IRAs provide parents and others the opportunity to save for a
child's education expenses in a tax advantaged account. The new tax law (this
portion effective beginning in 2002) increases the annual limit from $500 to
$2000 for contributions to these accounts. There is also a new income limit
for those making the contributions. Married couples filing a joint tax return
can make a full $2000 contribution if their adjusted gross income is less
than $190,000; they can make a partial contribution if their AGI is between
$190,000 and $220,000; and no contribution if their income is above $220,000.
For single taxpayers, the limit is one half of those amounts.
Earnings within the account are tax deferred and withdrawals are not
subject to tax if they are used for qualified education expenses. The new law
expanded this definition to include expenses for elementary and high school
expenses. Withdrawals not used for qualified education expenses are subject
to regular income tax and a 10% penalty. Withdrawals must also be completed
before the child reaches age 30.
Education IRA accounts function like IRA accounts and are available from
most banks, credit unions, brokerage firms and mutual fund companies.
Investment options vary depending on the firm. Usually there is considerable
flexibility with "self-directed" type accounts.
Qualified Tuition (Section 529) Plans
These college savings plans are now offered by over 40 states and were also
enhanced by the 2001 tax law. While the plans are offered by the state, there
is no restriction on where the child attends college. It is expected that
many universities will soon start offering these plans. One potential
drawback is that there are usually limited investment options. It makes sense
to look at several states' programs to find one that offers the investment
choices you desire.
With a Section 529 Plan, there are no income limits on the donors and
contributions of up to $11,000 per year can be made. In addition, there are
special provisions to allow a "front-end loading" of up to five
years of contributions to be made without gift taxes.
The big change made by the new tax law is that beginning in 2002
withdrawals used for qualified educational purposes are excluded from federal
income taxation. The law also loosened what institutions qualify, but there
are still some limitations.
Summary
Custodial accounts offer the greatest flexibility in terms of how the money
is ultimately used. However, they lack the tax benefits of the other
programs.
Education IRAs offer the greatest flexibility in terms of how the money is
used for education. However, there are limits on the income of the donors and
the annual contribution limit is $2000.
Section 529 Plans offer the highest contribution limits without income
limits on the donors. However, in many cases the investment options may be
limited.
As with most financial decisions, you must consider what you are trying to
accomplish. Be mindful of the tax implications and choose the one (or
combination) that best fits your situation.
