Pros and cons of gifting college money



Dear Joe, I will soon be coming into a small inheritance. I have two daughters, ages 4½ 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


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.

Popular Questions


Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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