School savings plans: prepayment option can avoid gift tax--but beware.

• Author: Lieberman, Philip R.

College costs are outpacing inflation, growing 9.8 percent at public four-year colleges and 5.7 percent at private four-year colleges in the 2004-05 school year, according to The College Board.

At this rate, new parents can expect average four-year college costs (including room and board) from $115,396 for public colleges to $221,562 for private colleges.

Given these escalating costs, CPAs often advise clients to use one of several options to help fund a child's college expenses, including 529 Plans, Educational IRAs and Custodial Accounts. While each strategy has its merits, each also has gift tax implications that can make them less desirable.

But a prepayment option, bolstered by a recent IRS Private Letter Ruling, may be an attractive alternative to such plans--and avoid gift taxes altogether.

Strategies for Saving

Before we dive into the prepayment option, here are the three most common education saving strategies:

529 Plans: Technically known as qualified state tuition plans, these allow users to contribute money into a tax-deferred account for higher education. Regardless of income levels, a donor may contribute $12,000 per year, per beneficiary, or $60,000 in a single five-year period ($120,000 for married couples) without triggering gift taxes.

The earnings in college savings plans grow tax-deferred from federal taxes. When funds are withdrawn, they are received federal income tax-free if used for qualified expenses, such as tuition, books, room and board.

If a child decides not to attend college, the deferred savings may be directed to an alternative beneficiary or the assets may be withdrawn. If the assets are withdrawn and not used for higher education, regular taxes and a 10 percent penalty may be imposed on the earnings.

Coverdell Education Savings Accounts: Formally referred to as Educational IRAs, these allow users to contribute cumulatively up to $2,000 a year for qualified elementary, secondary school and higher education expenses of a child. Withdrawals from Coverdell accounts are federal income tax-free if used for qualified expenses, such as tuition, room and board.

A beneficiary designation for a Coverdell can be transferred to another family member to pay for educational expenses. If the account is not used by age 30, or the funds are not used for higher education, regular income taxes and a 10 percent penalty may be imposed on the earnings.

Custodial Accounts: These accounts, from the Uniform Gift to Minors...