COLLEGE SAVINGS 101

Pros and cons of gifting college money

01/23/2006

QUESTION:
Dear Joe,

I will soon be coming into a small inheritance. I have two daughters, ages 4 and 22 months and would like to gift them some of the money to use for their college fund. As of today, I have not yet started saving for their college. I will have a military reserve retirement that will kick in about the time the oldest starts college and will be about $2,200 in today's dollars. This was what I had been planning on using for their college, until my mother died and left me some money. I'm not sure what is best to do with it -- put it in a 529 (and WHICH ONE?? There are so many.) or money market or CDs. Also, how much can I put into it at one time?
I prefer little risk.

Thanks.
-- Maureen

ANSWER:
Dear Maureen,
It's great that you are thinking toward future college needs while your children are still young. Any time that someone mentions "gifting" money to a child, however, I make a special effort to point out the pros and cons of that action.

Actually, there is only one significant "pro" to gifting money to your child: You may save on your taxes. You'll be removing investment income off your own tax return, and instead you'll be using your child's $850 standard deduction (in 2006) to soak up the interest, dividends and capital gains at no federal income tax cost. With two children, you have the potential to generate $1,700 in tax-free earnings each year. You will not even have to file federal income tax returns for them, as long as their income stays below the standard deduction amount.

Some planners will tell you to go even further in shifting income to your children, since income beyond the $850 standard deduction will be taxed in a low bracket (starting at 10 percent for interest and 5 percent for qualified dividends and capital gains).

But until your child reaches age 14 -- Congress has proposed upping this to age 18 -- the "Kiddie Tax" limits the low-bracket income to the standard deduction figure ($850 in 2006). The unadvertised part of this approach is that you'll also have to incur the time, frustration and perhaps added expense of preparing and filing tax returns for your children.

Other "cons" involved with gifting money to your children might easily outweigh any income tax savings. For one thing, the gifted money now belongs to your children, not to you. You can name yourself custodian of the money under your state's Uniform Transfers to Minors Act, or UTMA, and retain decision-making authority, but at the age of 18 or 21 (depending on your state's law), the money in the UTMA account must transfer to your child's direct ownership to be used in any way that he or she desires. Your best-laid plans for college funding may suddenly go awry if your child gets other ideas.

Assuming that college happens, as it in all likelihood will, the other major "con" is the impact of gifted money in determining financial-aid eligibility. The 35-percent inclusion factor for student-owned assets is more than six times the inclusion factor for parental investments. Over four years, you might be sacrificing more in financial aid than the entire balance in your child's investment account.

I would suggest you consider other ways to minimize the tax burden on your investments while maintaining control over the money and keeping your financial-aid eligibility intact. One option is to invest the money in your own name in a tax-efficient mutual fund or tax-managed brokerage account. You'll enjoy complete flexibility in selecting and managing your investments, and you can decide later on whether to tap the investments for college or leave them in place for retirement or other needs.

For even better tax efficiency, especially for someone such as you who prefers low-risk investments, consider Coverdell education savings accounts, or ESAs, and 529 plans. Since ESA contributions are limited to $2,000 annually per child, you might want to use them in combination with 529 plans, which can accept much larger contributions. When comparison shopping for a 529 plan, take a look at your own state's 529 plan first before considering the offerings of other states. You'll find plenty of investment options among the 80-plus different 529 plans -- although not as many as you can get with Coverdell ESAs -- and they can range from fairly aggressive to very conservative.

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