Imagine this:
As a proud new grandparent you decide to begin an ongoing plan of setting
aside money into a special account for your new grandbaby. Year after
year you make gifts, which are invested in stocks, in the child's Unified
Gifts to Minors Account. After 18 years, the account has now grown to
over $100,000! It is rewarding to know that your diligence has provided
your grandchild the opportunity to attend the best college in the country.
However, your special grandchild is no longer considered a minor and
is now entitled to all the money in the account. The child thanks you,
but announces grand plans to splurge on a new sports car, a fun-filled
vacation, and a combination of other luxuries that don't meet your approval.
College just isn't important and there's nothing you can do about it.
This seems like an unlikely scenario,
but it happens.
Establishing a college fund is very
important, but just as important is deciding how to title the college
fund. As a parent or grandparent, should the account be in your
name or in the name of the child?
Putting the college fund in the child's
name makes sense when considering that the child's
tax bracket may be lower. However, this may not be the case if
the "Kiddie Tax" applies (see below). There is also a
perceived value in setting aside college funds in the child's name
because you can tell yourself it is "for college" and
not be tempted to use it for other purposes. However, this means
that the money saved in the child's name will belong to the child
when he/she is no longer a minor. You relinquish control. Over
10-15 years, the investment can add up to a big sum and the child
may be tempted to spend it on a whim. Because of this, some people
choose to keep the balances in these accounts a secret from the
child. They may have the child sign a tax return each year with
little explanation of the specifics or have them sign a letter
each year directing them to "please take $15,000 from my account
to pay my college bills" in order to withdraw the funds out
of the custodial account. All in all, the tax savings benefits
and convenience of establishing a separate UGMA account for each
child makes sense for many people. The big consideration here is
whether you feel it is important to avoid any differences of opinion
over the true purpose for this account when your child is no longer
considered a minor.
Don't overlook the Kiddie Tax.
One of the pitfalls of the titling of assets is the taxation of investment
income of certain minor children. Investment income is considered to
be unearned income for tax purposes. For children under the age of
14 who have unearned income of $1400 or more, the investment income
is taxed at the marginal tax rate of their parents rather than the
child's lower rate. This is known as the "Kiddie Tax." Since
most parents have a higher tax rate than their children, this rule
could eliminate the benefits of transferring assets such as stocks
or bonds to their minor children. We would recommend that you consult
with your tax advisor or Dean Engel of our Investment Management Team
before transferring assets to children under the age of 14.
Why investing in your name makes sense -
You should consider the benefits of keeping the money invested in your
name. If the child decides to pursue endeavors other than college,
you will suddenly have a very nice nest egg for retirement. If the
child does decide to attend college, having the investments in your
name may be beneficial when college aid financial forms are completed.
Because of the way financial aid is calculated, saving in a parent's
or grandparent's name rather than a child's may mean more financial
aid will be available &/or the college may offer more financial
assistance. Also, establishing an education fund in your name does
not mean you will forego all tax benefits. For example, if you had
appreciated shares in your stock portfolio, you could use them to pay
college costs by gifting the shares to the child. The child could then
sell them and might, depending on your tax situation, pay a lower capital
gains rate. (See above information on the "Kiddie Tax.")
At this time, a married couple may make gifts up to $20,000 worth of
assets per year per recipient without owing gift tax.
Another option may be
to use your IRA accounts for funding your child or grandchild's college
education. Again, if the child doesn't attend college for one reason
or another, or receives scholarships for all of the expenses, you will
have a great retirement nest egg. If the funds are in a Traditional
IRA, any amounts used for higher education expenses for family members
will not be subject to the 10% premature distribution penalty. Eligible
family members include the IRA owner's spouse or any child or grandchild
of the IRA owner or the IRA owner's spouse. However, be aware that
distributions have to be coordinated with other education benefits.
For instance, if a student receives a Pell Grant or other tax-free
scholarship, in addition to a tax-free distribution from an Education
IRA or any other type of financial grant, the penalty free distribution
from the Traditional IRA will only be available up to the remaining
balance of actual expenditures to be paid.
If your funds are in a Roth IRA,
distributions of the principal or amounts invested, are always tax-free
and IRS penalty free. This would be a perfect investment strategy -
invest in a Roth IRA and use the principal for college education for
your child or grandchild. If there are no college expenses, the funds
will be available for retirement or as a tax-free legacy for your beneficiaries.
The earnings will be taxable but there will never be a penalty for
premature distributions if it is necessary to withdraw more than the
principal for your child or grandchild's education.
The decision on how to title an education
fund can be confusing. As you make your plans, visit with one of
our Investment Management Representatives to discuss your options.
We're here to help.
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