Pros and cons of college savings plans
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.
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
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
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.