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Custodial Accounts, Coverdell Education Savings Accounts and Section 529
For decades, parents
have used custodial accounts to transfer funds to their minor-aged children
to help build assets for college costs. However the 2001 tax law has enhanced
the tax benefits of other types of asset ownership that should be considered.
Coverdell Education Savings Accounts (Education IRAs) and Qualified Tuition
Programs (Section 529 Plans) have become very attractive.
Using a Uniform Gifts to Minors Act (UGMA) or Uniform Transfer to Minor
Act (UTMA) account is an easy and legal way to transfer the ownership
of assets to a child. With a UGMA or UTMA account, the parent creates
a custodial account on behalf of the minor child. Assets are transferred
into the account and the custodian, usually a parent, manages the account
until the child reaches legal age. At that point, the child can do whatever
he or she wishes with the assets.
Transfers to these
accounts are irrevocable. You cannot change your mind later and take the
assets back. Your child becomes the owner when you make the transfer an
on reaching the age of majority (18 or 21 in most states) the child can
do whatever they wish with the money.
Transfers into a custodial
account are just like any other gift. For 2014, you can make annual gifts
up to $14,000 in cash, securities or other property to anyone without
owing any federal gift tax and without filing a gift tax return. If you
are married, gifts can be considered to be half from you and half from
your spouse. This enables transfers up to $28,000 to be made. However,
a simple gift tax return may be required if you use this gift-splitting
technique. The annual $14,000 exclusion applies to each person receiving
When the assets become
the child's, any income the assets produce is taxed to the child. There
are special tax rules that apply to children under the age of 18, 18 year
olds with earned income less than half of their support, and 19 to 23
year old students with earned income less than half of their support.
These rules are commonly called the "Kiddie" tax.
The tax laws provide
that the first $1000 in 2014 of investment income from assets held in
the child's name is tax free. The next $1000 is taxed at the child's tax
rate (usually the lowest rate of 10%). Investment income greater than
$2000 in 2013, is taxed at the parent's rate until the child is no longer
subject to the Kiddie tax.
The Kiddie tax rules
were changed in 2007 and you may want to consult a tax advisor to determine
how the rules may apply in your situation.
Savings Accounts (Education IRAs)
Education IRAs provide parents and others the opportunity to save for
a child's education expenses in a tax advantaged account. The 2001 tax
law increased the annual limit from $500 to $2000 for contributions to
these accounts. There is also a new income limit for those making the
contributions. Married couples filing a joint tax return can make a full
$2000 contribution if their adjusted gross income is less than $190,000;
they can make a partial contribution if their AGI is between $190,000
and $220,000; and no contribution if their income is above $220,000. For
single taxpayers, the limit is one half of those amounts.
Earnings within the
account are tax deferred and withdrawals are not subject to tax if they
are used for qualified education expenses. The new law expanded this definition
to include expenses for elementary and high school expenses. Withdrawals
not used for qualified education expenses are subject to regular income
tax and a 10% penalty. Withdrawals must also be completed before the child
reaches age 30.
Education IRA accounts
function like IRA accounts and are available from most banks, credit unions,
brokerage firms and mutual fund companies. Investment options vary depending
on the firm. Usually there is considerable flexibility with "self-directed"
(Section 529) Plans
These college savings plans are now offered by over 40 states and were
also enhanced by the 2001 tax law. While the plans are offered by the
state, there is no restriction on where the child may attend college.
It is expected that many universities will soon start offering these plans.
One potential drawback is that there are usually limited investment options.
It makes sense to look at several states' programs to find one that offers
the investment choices you desire.
With a Section 529
Plan, there are no income limits on the donors and contributions of up
to $14,000 per year can be made. The annual limit increased from $13,000
in 2013. In addition, there are special provisions to allow a "front-end
loading" of up to five years of contributions to be made without
Custodial accounts offer the greatest flexibility in terms of how the
money is ultimately used. However, they lack the tax benefits of the other
Savings Accounts offer the greatest flexibility in terms of how the money
is used for education. However, there are limits on the income of the
donors and the annual contribution limit is $2000 and reverts to $500
in 2013 unless Congress takes action.
Section 529 Plans
offer the highest contribution limits without income limits on the donors.
However, in many cases the investment options may be limited.
As with most financial
decisions, you must consider what you are trying to accomplish. Be mindful
of the tax implications and choose the one (or combination) that best
fits your situation.