When saving for education, there's no shortage of available options. Unfortunately, the range of options is so broad that it's difficult to determine the best choice. Depending on where you live, how much income you have, and how old your child is, your answer may be different from someone else's. Getting through the maze of possibilities can be a full-time job. Indeed, there are now financial-planning consultants who focus entirely on education savings.
While it would take a book to go into great detail about every single option, you can get a brief and simple understanding of the available choices just by looking at the general categories. Some of the most popular ways of saving for education are custodial accounts, also known as UGMA or UTMA accounts; Coverdell Education Savings Accounts; and prepaid state tuition programs, also known as 529 plans.
Custodial accounts, also known as uniform gifts or transfers to minors accounts (UGMA/UTMA), are an extremely simple way to manage money for education. By establishing a custodial account, you are giving money to your child while retaining the rights and responsibilities of managing that money. By using a custodial account, you can open a wide variety of different types of accounts, from bank savings accounts and certificates of deposit to mutual funds and brokerage accounts. Even assets other than securities -- such as real estate and closely held business interests -- can be transferred using a custodial account.
The primary benefit of the custodial account is its simplicity. Financial institutions are almost universally familiar with custodial accounts and can establish one without any unusual paperwork. There is no requirement that the money within the custodial account be used for education; if the child chooses not to go to college, then the custodial account assets can be used for any other desired purpose without penalty. It's important to understand, however, that the custodial account may not be used by the parents for basic support expenses that they are already legally required to pay for their child.
The main downside of custodial accounts is that the parents lose control over the eventual disposition of the money. In most states, custodial account money becomes unconditionally available to the child at age 18 or 21. In some states, this means that if a parent saves substantial amounts of money in a custodial account with the intended purpose of financing an education, a child may be able to gain access to that money while still a senior in high school -- without any restrictions on its use.
In practice, this problem comes up less often than one might think. Most families that can afford to save substantial amounts in a custodial account also have other valuable assets, and it would often be foolhardy for a child to risk cutting off future gifts from parents by acting against their will with college money. Nevertheless, many parents find even the prospect of potential rebellion from their children unacceptable.
In addition, the tax treatment of custodial accounts has become increasingly unfavorable. At first glance, one might think that by using custodial accounts, a parent can transfer tax liability to a child, who almost certainly will have a lower income and therefore qualify for a lower tax rate. However, Congress found this loophole and enacted the so-called "kiddie tax" provisions, which imposes tax (at the higher rate paid by parents) on unearned income above a certain small amount. Initially, the provisions applied only to children under 14, so kids in high school could usually get the full benefit of lower tax rates. Recent tax legislation earlier this summer raised the age from 14 to 18, essentially eliminating the child's lower tax liability, regardless of age. Currently, therefore, a child could receive up to $850 in unearned investment income without paying tax, and up to an additional $850 taxed at the child's lower rate. Above $1,700, the tax rates paid by the parents would apply.
Finally, another significant negative is that assets held in custodial accounts are technically held on behalf of the child. Most financial aid calculations thus treat custodial account assets as the child's assets in determining eligibility for and the amount of any financial aid. In determining the appropriate amount of financial aid, assets owned by the child are treated differently from assets owned by the parents. As a result, financial aid formulas will generally require the child to draw down funds from custodial accounts much more quickly than other types of accounts that are technically held by parents or grandparents instead. The difference in required contributions from the custodial account can be as much as 30% of the account's value, based on the federal financial aid formula.
The custodial account works best in situations where relatively small amounts of money are involved, where the child is not certain about whether or not to obtain higher education, and where the child and parents are on the same wavelength about the responsible use of the money. If substantial amounts of money are available, the child is almost certainly going to college, financial aid and tax treatment are important factors, or the parents demand tighter control over the eventual use of the money -- then custodial accounts are not likely to be the best choice.
This article was originally published July 18, 2006.
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