How Uncle Sam wants you to save for college

Before 529s came into existence in 1996, parents often relied on UGMAs and UTMAs to save for college. That's because the custodial accounts allow parents to take advantage of their kids' lower tax bracket. For instance, the first $800 of unearned income for children 13 or younger used to be tax free. The next $800 was taxed at the child's lower rate. And the rest was taxed at the parents' rate -- until the kid turned 14, when all the unearned income would be taxed at the child's lower rate. This allowed parents to give appreciated stock to their kids, have the children sell the stock after turning 14 and then use the proceeds to pay for school.

But in 2006, then-President George W. Bush signed the Tax Increase Prevention and Reconciliation Act, which changed the kiddie-tax rules. Now the first $900 of unearned income kids receive is tax-free, the next $900 is taxed at the child's rate, and the rest is taxed at the parents' rate until the child turns 18. Because kids now have to wait until their senior year of high school or freshman year of college to take full advantage of their lower tax rate, custodial accounts are far less attractive for parents saving for school.

"In my opinion, UGMAs and UTMAs are essentially dead as a college savings tool," says Cal Brown, the vice president of planning at the Monitor Group, a wealth-management firm in McLean, Va.

Happy returns from a 529

An analysis by T. Rowe Price seems to back Brown up. Say you put $5,000 a year into a 529 for your daughter, and it earned 8% annually through investments in a blue-chip growth stock fund. After 18 years, you would end up with more than $218,000 for her college bills. By using a home-state 529 plan that offers residents a state tax deduction, you'd be likely to amass nearly $224,000, T. Rowe Price found. (Parents can choose any state's 529 plan; information about which plans offer tax breaks is at Savingforcollege.com.)

Now compare that with what you would save through a UGMA. Under the old rules, a typical parent in the 25% federal tax bracket could expect to accrue about $210,000 in the custodial account, according to T. Rowe Price. But under the new rules, you're likely to save even less: $207,700.

Plus, UGMAs and UTMAs are terrible from a financial-aid standpoint. As a rule of thumb, it's always better to save money in a parent's name because Uncle Sam expects only 5.6% of parental assets to be used to cover college expenses. The government assumes that 20% of the student's money can be used to pay for school.

By law, a custodial account belongs to the child, so having large amounts of savings in a UGMA or UTMA is detrimental for qualifying for financial aid. Yet assets form 529 plans are not considered student money for financial-aid purposes, according to federal rules.

If you've already started saving through a UGMA or UTMA, don't worry. Parents can roll over these accounts into a so-called custodial 529. While the money will still technically belong to the child, the assets will not be counted as student assets for aid purposes, even though the account maintains custodial status, the federal government has said.

Prepaid tuition gets a boost

What about prepaid-tuition plans, which allow parents to purchase units of future education at today's prices?

In 2006, the government gave these college savings vehicles a big boost by improving their financial-aid status. Under the old rules, the value of a prepaid tuition plan would reduce a student's aid eligibility dollar for dollar. But starting in July 2006, the government put prepaids on a level playing field with 529 savings plans. Both savings vehicles now help students qualify for aid since they are not considered student assets.

Even if you intend to use a prepaid plan to save for school, you will still probably want to start a 529 savings plan, too. That's because prepaid plans are good only toward tuition and fees. They don't typically cover room and board. And in recent years, room and board has become nearly as expensive as tuition at many schools, and more expensive at some.

The bottom line, no matter what type of college savings vehicle you now use, is that you probably need to consider opening a 529. "These recent changes," says Joe Hurley, the founder of Savingforcollege.com, "really made the 529 more attractive relative to all other college savings vehicles out there."

This article was reported by Paul J. Lim for U.S. News & World Report.

Updated May 20, 2009

< previous |  1 | 2 |