The Pillars of Education Planning
An ever-stressful topic among parents is how to accumulate sufficient resources to meet their children’s education funding needs. Ideally, the accumulation of resources for education costs should be based on an investment strategy that incorporates fundamental investment planning principles. Before an investment strategy is formulated a parent may wish to address four basic issues that may be critical to successful planning:
- control of investment assets,
- investment flexibility,
- investment taxation,
- financial aid concerns.
A sound first step is to address the question of who wants control of the assets. If the parent is not comfortable with giving up control of the investment assets that are going to be put aside for their child’s education, investments where the parent retains ownership should be explored. A 529 college savings plan may be a consideration since the account owner of a 529 plan, which is usually a parent, is in control for the life of the account. While the child benefits from the account, the child never gets control of the account, even at age of majority. A regular investment account owned by the parents could also be used to save for education. The parent keeps control of the assets and this may be what is most important.
If, on the other hand, the parent has no reservations transferring assets into their child’s name, then this can be easily accomplished by utilizing an UGMA/UTMA account. This, of course, comes with the understanding that if their child fails to go to college and instead wishes to become an avid European back-packer, it is the child’s money and he/she can do with it as he/she wishes upon reaching the age of majority. Remember that all transfers (gifts) to a child via an UGMA/UTMA account are irrevocable and the parent needs to be aware that this really does mean non-changeable.
While control may be an important factor, other aspects such as investment flexibility and the taxation of those investments should also be considered. For example, in a regular investment account which the parent completely controls, there is great flexibility in what the account can be invested in, but those investments will be taxed at the parent’s higher tax rate. Like the regular investment account, a 529 plan offers control but also offers additional tax advantages, such as tax-deferred earnings within the account with the possibility of federally tax-free* withdrawals for qualified higher education expenses. However, there aren’t as many choices when it comes to selecting investments.
With UTMAs/UGMAs, the child may obtain control of the account at age of majority, unlike a regular investment account. However, the way the account is taxed is more advantageous. UTMAs/UGMAs are taxed according to the “kiddie tax” rules. For children under age 14, the first $800 of unearned income is tax-free, and the next $800 is taxed at the child’s rate which is most often 10%. All investment income over $1,600 is taxed at the parent’s tax rate which could be as high as 35%.
Beginning in the year the child turns 14, however, the child's unearned income is taxed at the child's rate. Thus, UTMAs/UGMAs can be used as part of a strategy to shift unearned income to the child beginning in the year the child turns 14 in order to take advantage of what might be as much as a 25% tax bracket differential (35% vs. 10%). From a practical standpoint, with the child reaching the age of 14, the parents may start to get a good indication of what type of child they have, studious or European back-packer, and may be more comfortable in making the decision to transfer assets at this point.
Finally, weighing education savings options is beneficial to determine whether a parent with a college bound child intends to apply for financial aid, and if so, how assets owned by the child will be treated by colleges and universities during the financial aid needs review. Typically, 35% of assets held in the child's name may be deemed available to meet education expenses while 5% to 6% of the same assets may be deemed available if owned by the parent. The net effect may be potentially less financial aid for the child if assets are held in the child’s name. While UTMAs/UGMAs are considered assets of the child for financial aid purposes, 529 college savings plans and regular investment accounts are more advantageously counted as an asset of the parent if the parent is named as owner on the account.
Having an understanding of the “pillars of education planning” provides for a solid foundation from which to analyze education-funding decisions. Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this goal in light of your unique personal circumstance. Before implementing an education planning strategy, contact and consult with your financial advisor.
*Under a “sunset provision”, these changes are scheduled to expire on December 31, 2010, in the absence of re-enactment.
By W. Barton Close CFP®
Certified Financial Planner Board of Standards, Inc.,
owns the certification marks above, which it awards
to individuals who successfully complete initial and
ongoing certification requierments.