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Pros and cons of college savings plans

The financial-aid picture for the 2005-06 school year isn't pretty. More families will have to pony up extra money to put their kids through college during the next school year, according to a recent New York Times analysis. The reason: Changes were made in the federal financial-aid formula that requires a greater proportion of family income and assets to be counted toward college expenses.

"As a consequence, tens of thousands of low-income students will no longer be eligible for federal grants," The Times' Greg Winter reported in early June. While the changes don't affect all students across the country the same way, they are expected to have the most impact on middle-class families.

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Since free or cheap money is getting harder to obtain, it falls on us parents to prepare for our kids' college education if we possibly can. But it's hard to save for college while the kids are growing up. We have lots of competing demands on our income -- mortgage payments, private high school tuition perhaps, retirement-plan funding objectives and the usual everyday living expenses.

But if we allocate money toward college savings as an additional "mandatory" expense, we can accomplish a lot using one of many available investment vehicles. These are among the most popular.

Taxable brokerage account -- Obviously you get no tax-deferral benefits by allocating college funds to a regular brokerage account, but if you choose tax-efficient funds or buy stocks and hang on for the long term, you can minimize the tax consequences. Recent changes in the code reduce the tax bite on dividends and long-term capital gains anyway, to 15 percent at most, making regular brokerage accounts a more attractive place to stash funds than in years past.

These will be considered "parental assets" in the federal formula that determines the expected family contribution to college costs. That's a good thing, because a much greater share of students' assets are counted in the federal formula. Only 5.65 percent of parental assets are counted, vs. 35 percent of children's assets, according to Kalman Chany, author of "Paying for College Without Going Broke." Meanwhile, parental income is assessed at up to 47 percent vs. 50 percent for student income.

  • Negative: You don't get the magic of compound interest working for you as you would in a tax-deferred account.
  • Positive: You have a wide spectrum of investments to choose from. Also, these assets can be used for any purpose, so if your kid gets a free ride through school thanks to academic or athletic achievements, you can target the funds for a completely different goal.

UTMAs and UGMAs -- Once upon a time, these custodial accounts were the happening investment vehicle. Today they are less attractive than other college-savings vehicles that have sprung up in recent years. They're mini-tax havens, because the first $800 in investment income is not taxed at all. If your child is more than 14, any income above $800 is taxed at his or her rate. But if your child is less than 14, the kiddie tax kicks in.

  • Negative: Assets are in your child's name, which means two things can go wrong. When the student reaches the age of majority, the money can be spent for anything (on a brand new Honda Element, for instance). Even if it's kept for college expenses, the money is considered as student assets and subject to the 35-percent factor. Of course, if you're not likely to be eligible for need-based financial aid, this doesn't really matter.
  • Positive: Parents can transfer appreciated stock into these accounts to avoid paying taxes immediately. The capital gains tax rate for those in the lowest tax brackets (kids generally qualify) is temporarily reduced to 5 percent through 2007. In 2008, they get a capital-gains tax holiday, paying nothing. Then in 2009 it reverts to the previous capital gains rates. Also, because these custodial assets are shielded from creditors, parents in professions vulnerable to lawsuits (doctors, for example) sometimes use them to protect assets.
-- Updated: Oct. 20, 2006




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