College savings vehicles.

• Author: Raasch, Barbara J.

Today, it can cost over $35,000 per year to send a child to private college. Even in-state public universities can run over $10,000 per year. With these hefty costs staring parents in the face, it is no wonder they seek advice on how to reduce the burden. For years, tax advisers and financial planners have been formulating college-funding strategies designed to save taxes; yet the task continues to get more difficult and complicated. Federal tax roles have not changed much since the enactment of the Taxpayer Relief Act of 1997 (TRA '97), but the addition of new qualified tuition plans and the modification of already existing plans, state tax rules and changes in the economy continually affect funding strategies.

The TRA '97 provided much-needed aid to parents planning for their children's college education. It not only provided help in the form of the Hope Scholarship and Lifetime Learning Credits, but also created new planning investment vehicles, such as the Education IRA and college savings programs (CSPs). While the Education IRA disappointed parents and planners alike, (because of adjusted gross income (AGI) and maximum contribution limits), CSPs are gaining popularity as states improve their offerings. The changes raise the question of the "best" college funding strategy, which is more difficult to answer today than ever before.

Pre-TRA '97

Before the TRA '97, tax advisers focused on the income tax and estate tax benefits of transferring assets to a child using custodial accounts under the Uniform Transfers to Minors Acts (UTMAs) and the Uniform Gifts to Minors Acts (UGMAs) (see Exhibit 1) and irrevocable trusts (see Exhibit 2). This analysis centered on whether tax benefits were sufficiently large to outweigh the costs associated with masts, as well as the lack-of-control issues pertaining to custodial accounts (and, to a lesser extent, to trusts).

Exhibit 1: Custodial accounts (UTMA/UGMA)

* A custodian controls funds for a minor until he reaches the age of majority, which varies by state. Generally the age is 18, but it can be as high as 21.

* A custodian may not withdraw money, except for expenses that benefit the child. It is an irrevocable gift to the child.

* If a donor acts as an account's custodian, the value of the account will be included in the donor's gross estate. To avoid this, often one spouse makes a gift and the other spouse acts as the account's custodian.

* Generally, each individual can transfer up to $10,000 per year ($20,000 if a joint election is made) to an account without incurring Federal gift tax.

* The annual income is subject to kiddie tax for a child under age 14. For 2000, the first $700 of the child's income is tax-flee and the next $700 of income is taxed at the child's rate (presumably, 15%); any additional income is taxed at the parent's Federal marginal tax rate.

Exhibit 2: Irrevocable trusts

* A trustee makes all investment and distribution decisions, pursuant to the trust's terms.

* The provisions of a trust document cannot be changed. They dictate what funds can be used for, as well as how often and at whose discretion they can be withdrawn.

* Assuming a mast is properly drafted, generally, a donor will not include the funds in his gross estate:

* The annual gift tax exclusion of $10,000 ($20,000 if a joint election is made) applies.

* Generally, a trust not required to fully distribute its income annually pays no Federal income tax on its first $100 of taxable income. If it has to fully distribute its income annually, it is allowed a $300 annual exemption.

* Any income and capital gains not distributed by the trust are generally taxed at the mast's income tax bracket. The top Federal marginal bracket is reached at a relatively low income level (only $8,650 in 2000).

Sometimes a simpler solution better meets a client's needs. Simply saving for a child's costs in an investment account may be a viable alternative, because there are no incremental cost or control issues. In these cases, U.S. Series EE Savings Bonds (see Exhibit 3) may be appropriate, because they can provide Federal and state tax savings. While EE bonds are not expected to produce relatively high rates of return, they are insulated from losing value during a stock or bond market downturn. As a matter of fact, unlike other bonds, they...