Financial Answer Center

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 recently passed SECURE Act provides for many changes to retirement accounts as well as some tax-related items.

One change impacts the “kiddie tax,” which applies to the unearned income of minors generated within custodial UTMA or UGMA accounts. Unearned income above a certain threshold – $2,200 for 2019 (and 2020) – is subject to the kiddie tax. The tax was designed to prevent families from holding investments in the name of a minor to avoid or limit taxation.

Until 2018, the kiddie tax applied the parent’s marginal tax rate to unearned income above the threshold. The passage of the Tax Cuts and Jobs Act (TCJA) made changes to base the kiddie tax on the same tax schedule that applies to trusts and estates.

For 2020 and forward, the new law reverts the kiddie tax back to the previous method of applying the parent’s marginal tax rate.

Taxpayers have the option of applying either method – the tax rate associated with trusts and estates, or the parent’s marginal tax rate for tax years 2018 and 2019. A taxpayer wishing to change the method for 2018 would have to file an amended tax return. For taxpayers holding custodial accounts and filing 2019 taxes in the next few months, a key decision will be which method to use.

For tax year 2019, here’s a comparison of the trust/estate tax rate schedule vs. married filing jointly tax schedule:

When comparing the two tax calculation options for 2019, here are some considerations:

• Parents subject to the highest marginal tax rate already, or have lower amounts of unearned income subject to the kiddie tax, may find the trust and estate tax schedule more beneficial
• Parents in a lower-to-moderate tax bracket with larger amounts of unearned income subject to the kiddie tax may find that using their own marginal tax bracket (vs. the tax brackets for trusts and estates) may be more beneficial
• Given the complexity around the kiddie tax calculation, it is critical to work with a tax professional who can calculate each scenario to determine the best option

Planning considerations for tax mitigation
Depending on the amount of unearned income, parents may want to consult a financial advisor for strategies to mitigate the tax impact. For example, parents may want to change the underlying investments and select others that may not generate as much income or dividends subject to the tax.
If the funds are being saved for education, parents may consider transferring the account to a 529 college savings plan, where earnings grow tax free. Also distributions for qualified education expenses would not be subject to taxation. There are specific rules applied to assets in a 529 plan that originated from a custodial account, so it’s critical to consult with a financial advisor or tax professional.

Recently, Congress repealed the TCJA kiddie tax for 2020 and beyond. Facts and circumstances will dictate whether taxpayers should pay the TCJA or the non-TCJA kiddie tax for 2019 and whether they should amend their 2018 tax returns to secure potential refunds. (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 2020 (same as in 2019), the excess is subject to the gift tax rules. 

Pros
• Easy to establish and manage
• Free from income, contribution, or withdrawal limits
• Can invest in a variety of assets

Cons
• Less tax-advantaged than other accounts
• Can hurt child's financial aid prospects
• Irrevocably pass to child upon majority

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 21^st 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.

 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.