The unfavorable Kiddie Tax change wipes out two time-honored college-savings strategies. However, you can still save for college in at least three tax-smart ways. So life continues to be good as long as you keep your wits about you. Here's what you need to know.
Custodial Accounts and Crummey Trusts No Longer Work for College Savers
The new age-18 threshold for escaping the Kiddie Tax can greatly reduce or even eliminate expected federal income tax savings from setting up a Crummey Trust or an UGMA or UTMA custodial account to hold and invest funds intended to finance your child's future college costs.
For example, say you set up a Crummey Trust or a custodial account for your college-bound child a few years ago. You then gifted money to the trust or account and arranged for the funds to be invested. Since Crummey Trusts and custodial accounts are considered legally owned by your child, any gains or income from the investments are taxed to the child. To the extent the Kiddie Tax rules apply, however, the gains or income are taxed at your higher marginal federal rate. Not good!
Before 2006, it was pretty easy to dodge the Kiddie Tax problem by having the Crummey Trust or custodial account invest in growth stocks, tax-efficient stock mutual funds, and tax-deferred Series EE U.S. Savings Bonds. By hanging onto these investments until the year during which the child reached the Kiddie-Tax-free age of 14 (or a later year), the gains and accumulated interest income were generally taxed at rates paid by an unmarried taxpayer. This typically translated into a federal income tax rate of only 10% or 15% on interest income and only 5% on long-term gains. Sweet!
Sadly, the age-18 Kiddie Tax rule eliminates the advantage of following this "buy-and-hold" strategy — unless the investments can be held until at least the year during which your child turns 18. This is no problem for Series EE Savings Bonds, because they have no investment risk. But it's generally a bad idea for equity investments. You probably don't want to be forced into holding onto these more-volatile issues until right before your child's college bills start coming due.
If the Kiddie Tax problem isn't reason enough to give the cold shoulder to Crummey Trusts and custodial accounts, there's more. Funds in a custodial account will fall under your child's legal control after he or she reaches the state-law age of majority (usually 18 or 21, depending on where you live). Somewhat similarly, funds in a Crummey Trust will eventually have to be dished out to the child under terms that were established when you set up the trust. In other words, once you've contributed money to a child's Crummey Trust or custodial account, you can't get it back. It must be used for the benefit of that child.
Bottom Line: Please take my advice and forget all about establishing a Crummey Trust or an UGMA or UTMA custodial account as a college-savings vehicle. Before 2006, they had tax advantages that made them worth considering. Not anymore.
The Good News: These Three Strategies Still Work Just Fine!
While the Kiddie Tax age-18 rule makes Crummey Trusts and custodial accounts unworthy as tax-smart college-savings vehicles, you still have other attractive choices. Here are the top three, in order of how well I think they work.
Tax-Smart Option No. 1: Contribute to a 529 College Savings Account
Section 529 college-savings accounts have a great big tax advantage. Briefly, these state-sponsored programs are allowed to accumulate income and gains free of any federal-income-tax hit. When the account beneficiary (your child) begins his or her college career, federal-income-tax-free withdrawals can be taken out of the account to cover qualified education costs. Most, if not all, Section 529 plans now accept contributions of over $250,000. So you can fund the entire cost of an expensive education with a Section 529 account. Better yet, there are no income restrictions. These tax-smart college savings vehicles are available even to the "rich."
When funneling gobs of cash into an account intended for a your child's college costs, I think you should be quite concerned about what will happen to your dough if things don't go as expected. After all, your kid could decide to focus on body surfing instead of higher education. Happily, a Section 529 account gives you admirable flexibility to deal with such things. Specifically...
- You're allowed to change the account beneficiary without any adverse federal-tax consequences — provided the new beneficiary is a member of the original beneficiary's family and in the same generation or an older generation. So you effectively can take money out of a Section 529 account established for one child and move it into an account set up for another child, or even into an account set up for yourself without running up a bill with the IRS.
- Should you need to get the Section 529 account balance back into your own hands, that's permitted, too. You can pull back all or part of the money. However, you'll owe federal income tax, plus a 10% penalty on any withdrawn earnings. No tax or penalty is due on withdrawn contributions. That's a reasonable price to pay for being allowed to recover the money.
Warning: The preceding explanation describes what the federal tax law allows. Most Section 529 college-savings plans conform to these guidelines, but they are not required to do so. Make sure any plan you're considering does conform before making any contributions. For more information on Section 529 college savings plans, including state-by-state comparisons, I strongly recommend visiting savingforcollege.com2.
Tax-Smart Option No. 2: Contribute to a Coverdell Education Savings Account
Provided your modified adjusted gross income (MAGI) isn't too high, you can make annual contributions of up to $2,000 to a Coverdell Education Savings Account (CESA) set up for a child under 18. What's a CESA? It's an account set up by a "responsible person," which means you, to function exclusively as an education-savings vehicle for the "designated account beneficiary," which means your child. If you have several children, you can contribute up to $2,000 annually to separate CESAs set up for each one.
While CESA contributions are nondeductible, the account's income and gains are permitted to grow free of federal income tax. Then, federal-income-tax-free withdrawals can be taken out later to pay for your child's college tuition, fees, books, supplies, and room and board.
There's one big catch: Your right to make CESA contributions is phased out (gradually eliminated) between MAGI of $95,000 and $110,000 if you're unmarried or use married-filing-separate status. If you're a married joint filer, the phase-out range is between MAGI of $190,000 and $220,000. Fortunately, it's often pretty easy to work around this restriction. Here's how: If your MAGI precludes contributions, you can recruit another individual who has MAGI below the magic number to act as the "responsible person." Then that person can set up and make contributions to your child's CESA. For example, you may be able to enlist your parent to be the responsible person for your child's CESA. If so, you can simply give your parent the money each year to make the desired annual contributions to your child's account.
Now for a few more ground rules. CESA contributions are prohibited after the account beneficiary (your child) reaches age 18. If the CESA still has a balance after your kid hits turns 30, the account must be liquidated and all the money distributed to him or her within 30 days. But there's often a better solution. The "responsible person" (presumably you) can roll over the account balance tax-free into another CESA set up for a new beneficiary who is under age 30 and a member of the original beneficiary's family, like one of your other children.
The rollover privilege effectively allows you to use CESA funds for another beneficiary's education costs if the original beneficiary doesn't attend college or turns out to not need the money (perhaps because of scholarships). However, once you plow contributions into a CESA, you can't get the money back for yourself. Also, you lose all control over the account if you have to recruit someone else to be the responsible person. These two negative considerations don't apply to Section 529 accounts, which give us two more reasons to like them better.
Tax-Smart Option No. 3: Save With Your Own Taxable Brokerage Firm Account
You can keep things really simple by saving and investing for your child's college costs in your very own taxable brokerage-firm account. The maximum federal-income-tax rate on long-term capital gains and qualified dividends is locked in at only 15% between now and the end of 2010. This is a pretty good deal.
What if you still have some appreciated shares in the college account when your child hits college age? Consider giving some to the child. He or she can sell the shares, pay the capital gains tax hit at a lower rate (probably only 5% or less), and use the money for college. If your college account has some shares that have dipped below cost, you can sell them and claim the resulting capital losses on Schedule D of your Form 1040. Then use the cash to pay for college.
The Bottom Line
While the age-18 Kiddie Tax rule shuts some college savings doors, others remain wide open. The three options explained here are your best tax-smart choices in the current environment. Please take advantage.
Links in this article:
1 smartmoney.com/taxmatters/index.cfm?story=20060711
2 savingforcollege.com
By Bill Bischoff
