Education Planning Common Questions |
Should I Save For College In My Name Or My Child's Name?
Answer:
There is no right or wrong answer, just different consequences. Generally speaking, there are three potential drawbacks to saving in your child's name – the kiddie tax, the financial aid rules, and control issues. On the plus side, saving in your child's name can result in some tax savings, especially if your child is age 18 or older.
First, the kiddie tax. At one time, saving money in a child's name was recommended because of the tax saving opportunities that resulted when children were taxed at their own rate. However, Congress partially closed this loophole some years ago with passage of the kiddie tax. The kiddie tax applies to children under age 18. This rule makes all unearned (i.e., investment and savings) income over a certain amount subject to tax at their parents' rate. Specifically, for children under age 18, the first $850 of investment income is tax exempt, the second $850 is taxed at the child's rate, and any additional amount over $1,700 is taxed at the parents' highest tax rate.
If your child is under age 18 and you want to avoid the kiddie tax, choose tax-free or tax-deferred investments in which the annual expected income does not exceed the threshold amount of $1,700.
If your child is age 18 or older, the kiddie tax does not apply. The first $850 of investment income is tax exempt, and any additional amount is taxed at the child's rate. The advantage of this is that typically, your child's tax rate is lower than yours.
Keep in mind that certain financial aid rules come into play when your child holds an asset and is about to apply for financial aid. The federal government's formula for financial aid treats a child's assets differently than a parent's assets. Under current rules, a child must contribute 35 percent of his or her assets to college costs each year, whereas parents must contribute 5.6 percent of their assets each year (note: the 35 percent contribution figure for student assets is set to decrease to 20 percent beginning July 1, 2007). For example, $10,000 in your child's bank account equals a $3,500 contribution from your child, but $10,000 in your bank account equals a $560 contribution from you.
So the more assets a child has, the more he or she will be expected to contribute to college costs, and the less financial aid he or she will receive, because the financial need is less. However, obtaining less financial aid is not necessarily a bad thing. The average financial aid package consists mostly of loans, so by paying more up front, chances are you or your child will just incur less debt, as opposed to losing grants and scholarships (which do not have to be repaid).
Finally, there is the control issue. Many parents open a custodial account for their child (UGMA or UTMA) as a way to save for college. However, when the child reaches the age of majority (18 or 21, depending on the state), he or she gets full control over the money in the account and can use the money for anything – college, or perhaps a backpacking trip to Europe. Make sure you are willing to relinquish this control to your child.
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