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Who Should Own the Investments?

Deciding to build a college fund for your child is an easy decision; but deciding who should hold the money may be a more complicated one. You have three basic choices: put the money in your name, in your child's name, or in a trust with the child as the beneficiary. Your decision should be based on:

  • your marginal tax bracket;
  • whether or not you may qualify for financial aid; and
  • your net worth.

In Your Name

This is often the easiest solution, the least expensive, and it has several other advantages. First, since you own the money, you can decide exactly how it will be used. Although it is theoretically earmarked for college, you can use it for other purposes if necessary, such as meeting unexpected medical bills or purchasing a house. However, in general try to avoid setting up a fund for one purpose and then depleting it for another purpose.

Second, keeping ownership in your name is wise if you plan to seek financial aid. The financial aid formula is set up to assume that the student can contribute as much as 20% of his or her total assets to meeting college costs each year. However, you, the parents, are expected to contribute no more than 5.6% of your total assets each year. As an example, if you manage to save $35,000, the college will expect you to contribute about $2,000 toward college expenses. If it is in your child's name, they'll expect your child to contribute $7,000. You are much less likely to receive financial aid if you appear to have $7,000 to pay for college instead of only $2,000.

In Your Child's Name

The advantage of putting the funds in your child's name is, quite simply, taxes. Shifting assets to a child often minimizes taxes. And because the income is taxed at the child's lower rate, your family will be sending less money to the IRS and keeping more money to pay for school.

The tax advantage you receive depends upon:

  1. your tax bracket (determined by your taxable income) and
  2. your child's tax bracket and age.

Child Is under Age 19 or a Full-Time Student under Age 24

  • First $1,100 of unearned income not taxed in 2019 ($1,050 in 2018)
  • Next $1,100 of unearned income taxed at child’s tax rate in 2019 ($1,050 in 2018)
  •          After that the parental tax rate plays no role in determining additional tax. Instead, the brackets for trusts and estates apply. For 2019, that results in the following:

For Additional Income (above the first $2,200)

Kiddie Tax Rate

$0 to $2,600

10%

$2,601 to $9,300

 $260 + 24% above $2,600

$9,301 to $12,750

$1,868 + 35% above $9,300

More than $12,750

$3075.50 + 37% above $12,750

 IMPORTANT NOTE: Remember, putting substantial amounts of money in your child's name can backfire when it comes to getting financial aid. The money in your child's name is assessed much more heavily than money in your name when calculating financial aid. So, assets originally put in your child's name to reduce your tax bite may later reduce the amount of financial aid you can get (see the section Landing Financial Aid for details). (see the section Landing Financial Aid for details).

Custodial Accounts

A common arrangement for college funding is a custodial account. As the custodian, you have control over how the money is invested. Your child, as beneficiary, receives the benefit of being able to use the money to pay for college.

If you are not applying for financial aid or you want money to be in your child's name to reduce your income tax, a way to fund college costs is by transferring money to the child through the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA). Known as custodial accounts, they enable you to give money to a minor child while at the same time enabling you to maintain control over how the money is invested and spent. However, you cannot take this money back. This money no longer belongs to you. Once your child reaches the age of majority (either age 18 or 21), the money in a custodial account is his or hers to spend as they like. Your child should have a clear understanding of the family plan for funds in a custodial account.

It is easy to set up a custodial account. It is just like opening a bank account—the only difference is that you do not put your name as the owner on the account. You are named as the "custodian" and your child is named as the beneficiary. You make deposits and investments in the account or the fund just like you would if the account was in your name. The bank makes it easy on their application form to choose the custodial account form of ownership.

IMPORTANT NOTE:  If you give over $15,000 in 2019 (same as in 2018), the excess is subject to the gift tax rules. The $15,000 annual gift tax exclusion is indexed annually for inflation.

Funding Education with Trusts

A trust is a legal entity established for a given period of time that legally separates the powers of ownership from the benefits of ownership. Three types of trusts are commonly used for education funding:

Section 2503(c) trust

A Sec. 2503(c) trust is commonly used to provide for the education of a child. With a Sec. 2503(c) trust, the property and associated income must be available for distribution before the child attains age 21, and, generally, any remaining balance must be distributed to the child at age 21.

There are two advantages to the 2503(c) trust over an UGMA or UTMA. First, Sec. 2503(c) trust assets can remain in trust until the child reaches age 21, even if the age of majority in your state is less than 21.

Second, the child can also be given the power to extend the term of the trust. The power may be a continuing right or a right for a limited period of time (e.g., 30 days after the 21st birthday) to force distribution by giving written notice. If the child does not exercise the power, the trust will continue in accordance with the terms of the trust agreement.

Section 2503(b) trust

A Sec. 2503(b) trust requires mandatory distribution of income to the trust beneficiary annually or on a more frequent basis. This type of trust offers more flexibility than a Sec. 2503(c) trust or custodianship account. The Sec. 2503(b) trust has no requirements for distribution of principal, and may last for any fixed term, up to a lifetime. The principal need not pass to the income beneficiary, and can go to other persons you designate.

Crummey trust

This trust allows the trust beneficiary to withdraw some or all of any contributions made to the trust. As a result, the amount withdrawn will qualify for the annual gift tax exclusion. Furthermore, the trustee of a Crummey Trust may be given broad discretion over distributions of trust income and principal, and the trust need not terminate when the beneficiary reaches age 21.

Investment Income

Child's Name Versus Parent's Name

Investment Fund:

$10,000

Rate of Return:

6%

Invested For:

15 years (Child is 3 years old when you start)

Your Tax Bracket:

25%

Child's Tax Bracket:

10%

In Parent's Name

In Child's Name

Difference

15 Years Later Parent Will Have

15 Years Later Child Will Have

Your Family Has This Much More To Spend On College

$19,353

$22,009

$2,656

 IMPORTANT NOTE: Once your child comes of age (either age 18 or 21) the money in a custodial account is his or hers to spend as he or she likes—that could be for college or for a new car. Your child should have a clear understanding of the family plan for these funds.

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