Monday, August 3, 2009

Planning for College

As kids get ready to go off to college it is that time of year when parents swallow hard to pay for tuition, fees and expenses of a child's college education. For a child in Missouri the cost of a public education is approximately $17,000 per year. For a private school costs can exceed $50,000 per year. Few people can afford to pay for this out of their regular income. It takes a lifetime of savings and planning for this expenses.

What are the options for saving?

1. Parents can try to save money in their name. The plus of this is that the investment is in the parent's name and there is no loss of control. The downside is that the return on the investment is currently taxable at the parent's rate.

2. Specialized savings accounts in the child's name, i.e. Uniform Transfer to Minor's Account ("UTMA") and Uniform Gift to Minor's Account ("UGMA") are popular accounts at banks, savings institutions and investment firms. The advantage of these type of accounts are that they cheap and easy to set up. The investments in these accounts are taxed to the minor (subject to kiddie tax). The downside to these accounts is that when the child turns 21 in Missouri (in some states it is 18) the investment belongs to the child. For example, if your child wants to buy a motorcycle on his or her 21st birthday and take their significant other to Alaska you will not be able to do anything about it. For this reason, I do not recommend these accounts unless they are for very small amounts.

3. Section 529 College Savings Plans. Almost every state offers these accounts which are similar to an IRA. The main attraction is that the investment grows tax free inside the 529 Plan. If used for "Qualified Educational Expenses" the amounts expended for college are not taxable income. The parent (or better yet the parent's living trust) can be the owner of the 529 plan so that there is no loss of control. If the child does not go to college, the owner of the 529 plan can name a new beneficiary. Contributions are limited to $13,000 per year. A five year gift of $65,000 can be made up front; but, no other contributions can be made for a five year period.

4. An Irrevocable Trust. Another way to create a fund for future use is to set up an Irrevocable Trust. Let's say a Grandparent sets up an Irrevocable Trust naming the Parent as the Trustee for the benefit of a Grandchild (the "beneficiary") The Trustee can invest in anything that is fiduciallary appropriate. Grandparent can contribute up to $13,000 per year (the "annual exclusion gift"). If Grandparents want to make a joint contribution to such an Irrevocable Trust the maxiumum amount of the gift could be as much as $26,000 per year ($13,000 x 2 = $26,000) . In addition, a Grandparent could choose to make a lifetime gift up to $1M as part of their lifetime gift tax exemption amount to "supercharge" such a trust in addition to annual exclusion gifting. If Grandparent wishes to do so the trust can be made "defective". This means that for estate and gift tax purposes the Irrevocable Trust is outside of the estate of the Grandparent. But, for income tax purposes the earnings of the Irrevocable Trust can be picked up by the Grandparent and put on the Grandparent's income tax return. Why would a Grandparent might want to do this? Because, so far paying the income tax for someone else is not deemed to be a gift. In essence, the Grandparent's payment of the Irrevocable Trust's income tax is another way to transfer more wealth to the next generation. Meanwhile the Irrevocable Trust grows "tax free" so to speak. The earnings are compounded and re-invested in the trust each year. If the Irrevocable Trust could earn 7% a year for 10 years it would double in value. This is a wonderful way to create a supercharged savings plan for a grandchild. The trust can offer asset protection planning from the grandchild's creditors, predators and spouses for their lifetime if so desired.

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