New School Strategies

Advisors can help clients with college-bound children make the most of changes in two popular savings plans

A few months ago the federal government took two actions that parents of college-bound kids need to know about. One could be a boon to financial-aid applicants. The other closes the “ladder tax” loophole for UTMA/UGMA accounts.

First, the Department of Education (DOE) altered the financial-aid treatment of certain 529 plans. Then the Internal Revenue Service (IRS) tweaked custodial accounts.

Both bits of fine-tuning are likely to change the thinking of many parents who are using the methods to save money for their children's college educations. What that means for you is that an opportunity has opened up to reduce taxes and get more financial aid for families who are saving for their children.

The DOE and the Dough

Two of the biggest benefits of saving money for college in parental-owned 529 plans are the ability of the owner to control the money and the fact that dispersals for qualified expenses are tax-free. A lesser-known but still-important attribute is how the government system treats money in parent-owned plans.

Individual schools reserve the right to use their processes for determining financial aid. But the most widely used system for determining need-based awards is the Federal Methodology that was developed by the DOE. According to this method, each year no more than 5.6 percent of the money in a parent-owned 529 account would be considered available to cover school expenses before any aid is given.

A sweet arrangement, especially when compared to money invested in child-owned accounts (like custodial accounts — see sidebar), from which schools can siphon up to 35 percent of the value each year in advance of any need-based grants, loans or scholarships. If the account balance in question were $100,000, then $35,000 has to come out before any aid is given — if the money is in the child's name. But only $5,600 would have to be ponied up from parent-owned accounts (including 529s).

At least that's the way it was until May. While you were financing a tank of gas for your Memorial Day vacation, the DOE changed the financial-aid treatment of child-owned 529s. Basically, the new rule is that these accounts are “invisible” when deciding how much aid should be given.

Enter the Tax Man

Not to be outdone by their bureaucratic brethren at the DOE, the IRS has also thrown a curveball at families who are saving money for their children in the custodial savings accounts established under the “Uniform Transfers to Minor Act” (aka “Uniform Gifts to Minor Act”).

Until recently, annual earnings on investments held in UTMA/UGMA accounts for a child under age 14 were taxed as such:

First $850 Tax free
Next $850 Taxed at child's rate
Anything over $1,700 Taxed at parent's rate

Once the child reached 14, all earnings on savings and investments were to be taxed at the child's (usually) low rate.

This window allowed wealthier families to reduce their overall income tax bill by giving money and other assets to preteens, who upon turning 14 years old would pay lower taxes on the investment earnings. Better yet, parents in the upper-income brackets could assign highly appreciated assets to college-bound children. The children would then sell the investments themselves, which could cut the capital gains bill in half.

That window closed in May when legislation was enacted that raised the magic number from 14 to 18. The new law means families with children aged 14 to 18 could have investment earnings in child-owned accounts taxed at twice (or more) the rate they would have previously paid.

Counter Punches

The new rules give you an opportunity to help clients stiff-arm higher future taxes on teen assets — but only on money already established in the child's name. Here's how to handle the most recent twists to the tax laws and financial-aid rules.

“There's a clear financial advantage” to transferring the custodial accounts into a child-owned 529, says 529 guru Joe Hurley, the proprietor of Savingforcollege.com.

The strategy may result not only in a dramatic increase in the eventual financial-aid package offered by a school, but if the proceeds are used for qualified higher-education expenses, the future earnings and withdrawals will be tax-free — rendering Uncle Sam's recent boost in the kiddie tax moot.

Avoid Desperate Acts

Just because financial-aid departments may be favoring UTMA/UGMA 529 accounts, it doesn't mean parents should rush out to transfer money into child-owned 529s. The potential reward doesn't outweigh the negatives. “Parents should not give up control (of the money) unless there is a clear advantage to doing so,” says Hurley.

The danger is twofold: First, it would be difficult to transfer the child-owned 529 to another family member. And second, if the child decides to spend his 529 proceeds on nonqualified expenses, there will be taxes and penalties on the earnings portion of the withdrawals. Finally, Hurley warns, “Some schools may count a child-owned 529 more heavily for school-based financial aid.”

But there is still business to do — by transferring UTMA/UGMA accounts to child-owned 529s and encouraging parents to save new money in parent-owned 529s.

Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com

Fine Points

You need to heed a couple caveats before rolling child-owned money into a child-owned 529:

First, 529 plans have to be funded with cash, so liquidating investments in an UTMA/UGMA account to fund a 529 may trigger a capital gains tax. Of course, the tax would have to be paid someday, but selling when the child is over 18 may mean the gain could be taxed at a lower rate.

And if you are selling UTMA/UGMA assets to fund a 529 and the family is likely to apply for financial aid, try to complete the sale at least two calendar years before the the child is going to apply for financial aid. Otherwise, the sales proceeds may artificially boost the child's apparent wealth and reduce financial aid that would have been awarded for the first year of school.

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