PLANNING FOR A CHILD'S COLLEGE EDUCATION
There are a number of options available for saving for a child’s college education.
529 Plans. 529 plans are tax-advantaged accounts for funding higher education. All 50 states have them, and the particulars of the different plans vary, including maximum contribution levels and fees (out-of-state plans or those purchased through an investment advisor can have significant sales loads). Contributions to the account are not eligible for a federal income tax deduction, but may be eligible for a state income tax deduction, as in New York. Account dollars grow tax-free, and withdrawals for “qualified higher education expenses” – such as tuition, room and board, books and fees for college and graduate or vocational school, as well as costs for a computer and related software and equipment – are free from federal income tax, and may be free from state income tax as well.
Pros: In a single year, a 529 account can be “front-loaded" with five years’ worth of annual exclusion gifts ($75,000 in 2018 (5 x $15,000), or $150,000 if a spouse agrees to split the gift). The gift doesn’t erode any of the donor's $11.2 million lifetime gift and estate tax exclusion, and allows for tax-free growth. Although the donor can change beneficiaries, the account is not includible in the donor's taxable estate. Furthermore, as long as the new beneficiary is a family member and not in a lower generation than the prior beneficiary, there are no gift or generation-skipping transfer tax consequences. The donor can withdraw his or her contributions if the donor later needs the money, subject to a 10% penalty and income tax on the account’s earnings (the same consequences as if the donor names a non-family member as the new beneficiary).
Cons: The donor's investment choices are limited to the plan’s offerings. Also, some plans may have costly sales loads. In addition, if the donor switches from one state plan to another, the initial state may impose a tax or penalty on the account, particularly if it generated any state income tax deductions.
Custodial Accounts: UTMA and UGMA. Custodial accounts refer to accounts under UTMA (Uniform Transfers to Minor Act) and UGMA (Uniform Gifts to Minors Act). These accounts facilitate giving property to a minor child, whether the donor wants to set aside money for college or get property out of his or her estate for planning purposes. All but two states have gone from UGMA to UTMA, a broader and more flexible Act. This basically means that the UGMA account is now governed by UTMA, except as to when the account must terminate. That is, even though most UTMA accounts terminate when the beneficiary reaches age 21, UGMA accounts usually terminate at age 18, unless the donor specified age 21 when he or she set it up.
UGMA and UTMA accounts are currently taxable to the beneficiary, and are subject to the “kiddie tax”. Given this, custodial accounts are even less attractive, and unlike 529 plans and ESAs, do not offer tax-deferred growth.
Pros: Custodial accounts are a simple way to set aside property for a child. The custodian may use the account to benefit the child in any way he or she sees fit, as well as direct the investments.
Cons: Custodial accounts can accumulate significant dollars that the donor may be reluctant to see fall into the hands of his or her 18- or 21-year-old. If the donor uses the account to help support his or her child, the donor will be taxable on the account’s income (which presumably will be taxed at his or her top rate anyway because of the kiddie tax). The donor may not reclaim the property, since the account belongs to the child (and is therefore the child’s asset for financial aid purposes). Finally, if the donor funded the account and is the custodian, the account will be included in the donor's estate if he or she dies before the account is turned over to the child at age 18 or 21.
2503(c) Trust. A 2503(c) trust is for a minor; it is designed to receive annual exclusion gifts (currently $15,000 per year, or $30,000 if the donor’s spouse consents), but doesn’t require Crummey letters when the donor contributes to it (see Crummey Trusts, below). The trust is solely for the child for whom it is created, and is taxable in the child’s estate if he or she dies before the trust terminates. When the child reaches age 21, the trust must pay out to the child, or the child must have the opportunity (say, for one month) to withdraw all of the trust’s assets. If the child doesn’t withdraw the assets, the trust continues according to its terms, and the child becomes responsible for paying the trust’s income taxes (yes, the trust becomes “grantor” as to the child, to whom the “kiddie tax” may apply). Although trusts benefit from the preferential rates for qualified dividends and capital gains, they have extremely compressed rate brackets and in 2018, are subject to the top 39.6% rate at taxable income over $12,400. In addition, trusts are subject to the 3.8% tax on “net investment income” (see above).
Pros: As mentioned above, annual exclusion gifts into the trust do not require Crummey letters. Also, the trust can be as flexible as the donor wants, unlike a 529 plan or an ESA.
Cons: The child can terminate the trust at age 21, although the donor may persuade otherwise.
Crummey Trusts. Like the 2503(c) trust mentioned above, Crummey trusts are designed to receive annual exclusion gifts. The trusts are not limited to minors, however, and can have multiple beneficiaries. If, for instance, the donor sets up a Crummey trust for his or her child, the trustee must write to the child, informing him or her of the donor's annual contributions to the trust and of the child's right to withdraw that contribution for, say, 30 days. This withdrawal right is called a “Crummey power” (after the taxpayer who litigated the issue) and ensures that the donor's gift into the trust is a “present interest” that qualifies for the annual exclusion and does not erode the donor's $11.2 million lifetime exclusion. The trust can include whatever provisions the donor likes, and can last well beyond the child's lifetime. The trust is generally responsible for its own income taxes unless the donor has structured the trust so that he or she must pay those taxes (a “defective grantor trust”); note that the trust or the donor may be affected by the 3.8% tax on net investment income.
Pros: The donor only has to worry about the child withdrawing the donor's annual contribution, and not the whole trust when he or she turns 21, as with a 2503(c) trust (see above). A Crummey trust can be as flexible as the donor wants in terms of provisions and payouts, provides a solid asset management structure, and makes sense if the donor anticipates that other significant gifts will go into the trust.
Cons: Trusts, particularly those with Crummey provisions, are more involved than 529 plans, ESAs or custodial accounts. If the donor doesn’t intend to put much property into the trust, it may not be worth it, and finding a cost-effective trustee could be difficult; the annual Crummey notices may also be burdensome. In addition, the donor must be careful about the control he or she retains over the trust so that it won’t be includible in the donor's estate if he or she dies before the trust terminates.
Saving for a child’s education requires planning and financial commitment. Although various options are available, there is no one “right” answer – just choices, depending on how much parents intend to save and whether they want the funds solely for educational expenses. Please contact Lara M. Sass, PLLC to discuss the option best-suited to your needs.