COLLEGE SAVINGS 101

Turning grandparents' gift into a college fund

04/01/2006

QUESTION:
Dear Joe,

My wife and I just had our first baby and my parents gifted her $22,000 ($11,000 each). I'm trying to understand the following: What types of accounts should I be considering and which would be the best? If I simply opened an account in her name, can I be a joint owner of the account?

-- Bill

ANSWER:
Dear Bill,
$22,000? Wow! Your child is probably the wealthiest newborn in the neighborhood. Your parents are obviously full of pride and joy for their new grandchild, and their generous gift also suggests a healthy checkbook. But before getting to your question about investment accounts, let's explore in a little more depth the concept of grandparent gifting.

Did your parents also make a large gift to you (and perhaps to your spouse as well)? If so, it tells me they are following a plan to reduce their estates while avoiding gift taxes, most likely at the suggestion of their attorney, accountant, or financial adviser. The easiest way to minimize estate-tax exposure, besides spending or donating money, is by making gifts of cash or property to younger-generation family members and taking full advantage of the $12,000 gift-tax annual exclusion (in 2005 the limit was $11,000).

However, if your parents are bypassing you in favor of your daughter, you might want to suggest (gently) that they alter their future gifting strategy. If they continue to make large gifts directly to your daughter, she will have a six-figure investment account by the time she becomes a teenager. Although your daughter will not have direct access to these funds until she reaches the age specified under your state's laws, generally 18 or 21, one can just imagine her anticipation as that magical birthday approaches! You may be planning for that money to go toward a college degree, but your power to control that evaporates when your daughter reaches legal age.

Other problems can crop up when substantial gifts are made directly to a grandchild. For example, financial aid eligibility is compromised. Student-owned investments are counted heavily when figuring the family's expected contribution toward college costs. A reduced aid award can be particularly disheartening for parents struggling to keep up with their own financial obligations.

Another issue has to do with income taxes. If your daughter's reportable investment income in 2006 exceeds $850, you face the extra burden of preparing and filing a federal income tax return for her. Of course, you'll save some taxes by utilizing her lower tax bracket, but the "kiddie tax" serves to cap the tax-bracket benefit.

Convincing your parents to use a 529 plan instead of direct gifting will solve most, if not all, of these potential problems. Their contributions to a 529 plan are treated as gifts that come out of their estates. Yet, your daughter will never gain direct access to the 529 funds. The earnings will be tax-deferred, eliminating the cost and hassle of federal income taxes as the 529 account builds over time. And for purposes of federal financial aid, a 529 account is not considered a student's asset even if it is in the name of the student.

Your parents could set up their own accounts with a 529 plan, naming their granddaughter as beneficiary on those accounts. Or they could delegate the responsibility to you by making contributions to a 529 account under your ownership (assuming the particular 529 plan accepts nonowner contributions). Whoever is named account owner enjoys all the legal rights to the account, including the right to change beneficiaries and the right to request distributions for the owner's own benefit. (Distributions not used for the beneficiary's qualified higher education costs are subject to tax and, unless an exception applies, to a 10-percent penalty as well.)

It's probably too late to change the fact that $22,000 has already been gifted to your daughter, making it subject to your state's Uniform Transfers to Minors Act (UTMA). When you place the money in a bank or investment account, you would typically set up the account not as joint owners but, rather, in your name or your spouse's as custodian for the benefit of your daughter. You could contribute the funds to a 529 plan and take advantage of the income tax benefits and financial aid advantages, but your daughter will still be able to claim direct ownership of the 529 account when she reaches legal age.

As always, you should rely on your own legal, tax, and financial professional for advice specific to your situation.

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