For most of us, paying for college for our children means some combination of 529 Plans, regular savings, our current income while the children are in college, and the children working and saving themselves.
529 Plans really only make sense if we start early and are (or anticipate being) in an income-tax bracket that makes the tax-free growth worthwhile. Why, you may ask, does your tax bracket matter? Couldn’t you just give money to your child in a custodial account (“Uniform Transfers to Minors Act” account) which you control until the child is 21, have that taxed at the child’s (low) rate, and use it to pay for college?
There are two problems with that (possible gift tax issues aside). The first problem is the Kiddie Tax.
For tax year 2019, the Kiddie Tax applies if your child has unearned income exceeding $2,200, is required to file a return, isn’t filing jointly, and was age:
- 17 or younger at the end of 2019;
- 18 at the end of 2019, but only if their earned income (excluding scholarships in the case of a full-time student) didn’t exceed half of their support costs in 2019; or
- 19 – 23 at the end of 2019, but only if they were full-time students and their earned income (excluding scholarships) didn’t exceed half of their support costs in 2019.
If the Kiddie Tax applies, the child’s unearned income is taxed pursuant to the tax rates and brackets applicable to trusts and estates. (This was a change starting in 2018. The old rules were that the child’s unearned income was taxed at the parents’ marginal tax rate.) Trusts hit the top federal income tax rate at an annual income of just $12,750, so the brackets are quite compressed and punishing.
The point is, you can’t really save income taxes by giving away investment assets to your non-adult children. It may even cost you money.
The second problem is how college need-based financial aid treats assets, depending upon who is the owner. Need-based college financial aid (as opposed to merit-based aid) generally reduces the amount of aid awarded based on the assets of different persons in different ways.
Student assets will reduce eligibility for need-based aid by 20 percent of the net worth of the asset. This includes assets such as custodial accounts. So a $100,000 custodial account would reduce need-based financial aid by $20,000 that year. Assuming that $20,000 was spent and the account did not grow, the now remaining $80,000 account would reduce aid by $16,000 for sophomore year. Etcetera.
Assets owned by parents are treated significantly better. Some parent assets are sheltered by the financial aid formula, such as the primary residence. The remaining reportable assets are assessed on a bracketed scale with a maximum rate of 5.64 percent. Again, that is per year.
Assets of grandparents and other persons are not considered at all. That sounds really good, but it isn’t. More in Part 2 about this.
Then there are trusts. Unfortunately, the FAFSA and other reporting tools are generally not sophisticated at all regarding trusts. If you child is the beneficiary of a trust, it is reportable, and generally any restrictions on trust distributions, or whether your child is one of many beneficiaries who share the trust, is not taken into account, and the entire trust principal is regarded as an asset of the child’s, and thus subject to the 20% rule shown above.
In Part 2, we’ll look at how 529 Plans are treated as Assets and how 529 Plan distributions are treated.
In Part 3, we’ll consider how a combination of 529 Plans and Trusts might be a good approach for some.
Special Needs Law Group of Massachusetts can advise you on creating an estate plan that fits your unique circumstances and may include funding a college education.
Learn more about Special Needs Law Group of Massachusetts here.
This blog post does not constitute legal or tax advice, even if you are presently a client of Special Needs Law Group of Massachusetts, PC, nor is an attorney-client relationship created by reading it. If you want legal or tax advice, you should retain a licensed attorney or tax advisor for that purpose.