By: The Financial Planning Association
The new tax act is sparking debate among experts as to what college-savings vehicles are now best for families. While it’s certainly worth taking a new look at the options, keep in mind that what’s best ultimately depends on your specific situation and needs, such as level of income, financial aid and a desire for control.
Unlike the tax act in 2001, which significantly altered the landscape of college funding, the Jobs and Growth Tax Relief Reconciliation Act of 2003 did not directly address college funding. Rather, its impact lies mainly in its reduction of the taxes on capital gains and dividends, and as a result, whether 529 savings plans have lost some of their much-touted advantage over college-funding alternatives, in particular custodial accounts and taxable stocks.
Individual states sponsor 529 plans, and the plan assets accumulated from participant contributions are managed by professional money managers, much like mutual fund assets. These plans gained an enormous edge in popularity over most other college-funding alternatives when the 2001 tax act made plan earnings withdrawn for qualified college expenses exempt from federal income taxes and most state income taxes. Many states added incentives such as state income tax deductions for contributions. (Qualified withdrawals from Coverdell education savings accounts also are free of tax, and often have low fees, but these plans have contribution and income limitations that make them less attractive than 529 plans.)
The 529 plan edge, argue some experts, was dulled when the 2003 tax act lowered capital gains rates and slashed stock dividend rates from ordinary income tax rates to the equivalent of the new capital gains rates. The capital gain rate dropped from 20 percent to 15 percent for higher-income taxpayers, and from 10 percent to 5 percent for lower-income taxpayers (zero in 2008). Because students usually fall into the lowest tax brackets, the new tax rates are giving alternatives new luster, contend some.
Take custodial accounts, for example. These accounts, established under either the Uniform Transfer to Minors Act (UTMA) or the Uniform Gift to Minors Act (UGMA), are vehicles for making irrevocable gifts to minors. For children under age 14, the first $750 in annual account earnings is exempt from tax, the next $750 is taxed at the child’s rate and the remaining is taxed at the parents’ rate. Once the child turns 14, all earnings are taxed at the child’s rate.
Assuming the taxable earnings are all long-term capital gains or qualified stock dividends, the child 14 or over would probably pay the lowest tax rate. Furthermore, parents can direct investments in a custodial account, which isn’t possible with a 529 plan. Custodial account fees also are typically lower than 529 plan fees, which have been criticized for being too high. Furthermore, custodial account funds aren’t restricted only to college expenses, unlike the funds in 529 plans.
But proponents of 529 plans point out that two major downsides remain for custodial accounts, despite the lower tax rates. First, custodial accounts currently count more heavily against potential needs-based financial aid than 529 plans because the funds are in the child’s name. Second, the gift to the account is irrevocable. The child assumes control of any remaining funds when he or she reaches the age of majority (18 or 21).
The lower capital gains and dividend rates also make more attractive the outright gifting of stocks or stock mutual fund shares to the student, who can then sell assets at the lowest capital gains rate. This strategy allows the parent to control the investments up to the time of the gift, which would not likely be made until the child is near or in college.
Which of these or other strategies to implement in the wake of the new tax act will depend on your tax bracket, whether your child expects to receive financial aid and your desire to maintain control of the assets, among other factors. Furthermore, the entire landscape could change again because all of these provisions, including the tax-free withdrawals of 529 plans, are set to expire within the next few years. Which is why, in the end, the best strategy is simply putting away money every month for college, regardless of the vehicle or the changing tax laws.
October 2003- This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Frank Armstrong, CFP, a local member in good standing of the FPA.