January 23, 2017 in Savings

Opening a savings account in a child’s name may seem like a really smart move, a way to give a little one a head start on a lifetime of thrift. However, it’s a decision that you might come to regret when college years approach.

Picking the wrong savings vehicle for your children’s future college cash needs could cost them thousands in avoidable taxes and missed financial aid.

“There is an asset protection allowance, or APA, that protects a portion of the parents’ assets, based on the age of the older parent,” when determining financial aid, says Mark Kantrowitz, publisher and vice president of strategy at Cappex.com and an expert in student loans and financial aid.

But students’ income and savings have a bigger, more negative, impact on the availability of financial aid than parental assets and income.

Because financial aid is determined based on income and assets from the year prior to applying for aid — in most cases, the student’s junior year in high school — students with sizable savings in their name could end up losing a large sum of free college money.

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Fortunately, there are several ways for parents to save that will not put their children’s future financial aid in jeopardy. Here are four places to safely stockpile cash:

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529 college plans

One popular way is to save for college through a college savings plan.

Operating in a fashion similar to IRA and 401(k) plans, 529 college savings plans allow parents to save for a child’s education tax-free through a variety of investment options. Some age-based investment packages put funds in aggressive investments when the child is young, then automatically switch funds to more stable options as the child nears college age.

These plans offer big tax advantages, says Craig Parkin, a managing director at TIAA-CREF, the investment organization that administers state-sponsored college savings plans in California, Kentucky and other states.

“The gains on the accounts are tax-deferred, and once the funds are used to pay for qualified tuition expenses, parents will never pay taxes on those funds,” he says.

Money in these accounts can be used for undergraduate or graduate studies at any accredited two- or four-year campus in the United States. Savings in a 529 plan belong to the parent, not the child.

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“A 529 college savings plan is considered a parent’s asset because the parent is the account owner and they can change who the beneficiary is,” Parkin says.

Kelly Campbell, a certified financial planner and founder of Campbell Wealth Management in Alexandria, Virginia, cites another advantage of these plans.

“An additional benefit with a 529 plan is that if the child says they don’t want to go to college, the parents or whoever owns the account can change the beneficiary,” Campbell says. “That way, you know the money will be used for education. They can’t just take it and run.”

While 529 savings plans offer major advantages, they also come with some restrictions. According to the U.S. Securities and Exchange Commission website, 529 college savings funds can be withdrawn tax-free only for qualified education expenses, including tuition, books, fees, supplies, and room and board. Money spent on unqualified expenses is subject to income tax and a 10 percent penalty on earnings.

There are also restrictions on how money in these plans can be invested. For instance, account owners can switch the investments in their plan only twice a year.

Prepaid tuition plans

A prepaid tuition plan is an alternative to a 529 savings plan that may appeal to some parents. Designed for parents who are sure that their child will attend an in-state public university, this plan allows parents to simply pay for tuition credits in advance at a predetermined price.

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Prepaid 529 plans retain the same tax, financial aid and parental protections as 529 college savings plans, but without being subject to swings in the stock market.

“The major limitation to a prepaid plan is that if the child decides to go to school out of state, they’ll get a return on their money, but they won’t get the full value of the plan,” says Parkin. “For example, if someone bought one year of tuition at a Kentucky state school for $12,000 and now tuition is up to $20,000, they would get a full year of college. If they decide to go to school in, say, Ohio, they would get a return — probably $13,000 or $14,000 — but they wouldn’t get the full $20,000.”

Like 529 college savings plans, prepaid plan holders can change beneficiaries at any time, but must pay a 10 percent penalty plus income tax on funds used for anything other than college tuition.

“You can have the prepaid plan to pay for tuition and a 529 college savings to pay for other expenses,” says Parkin.

UGMA and UTMA accounts

If the child doesn’t plan to attend college and therefore isn’t at risk of losing financial aid, UGMA and UTMA custodial accounts offer standard tax breaks for children under 18.

UGMA stands for the Uniform Gift to Minors Act. UTMA stands for Uniform Transfer to Minors Act.

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In these accounts, the first $1,000 in gains is tax-free, the second $1,000 is taxed at the child’s income tax rate and the remainder is taxed at the parent’s income tax rate, according to the IRS. Plus, there are no restrictions on how the funds may be used as long as they directly benefit the child.

The downside of UGMA and UTMA accounts is that parents have less control over how the child eventually spends the money, says Michael Kay, a certified financial planner and president of Financial Life Focus, a financial planning firm in Livingston, New Jersey.

“If money is in a UTMA or a UGMA account, it becomes (the beneficiary’s) at the age of majority, which is 18 to 21, depending on the state,” he says. “There’s no legal way to prevent the child from using money that was intended for college or a house to go to Europe.”

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Roth IRA

Finally, parents can give a kid a financial head start by opening a Roth IRA in the child’s name once he or she begins earning income.

While offspring over the age of 18 retain control of the account, restrictions on Roth IRA withdrawals keep investors from taking earnings out penalty-free until the age of 59 1/2.

However, there are exceptions to this rule that allow early withdrawals due to certain circumstances (hardships such as a disability) or for specific types of spending (such as purchasing a first home or for qualified education expenses).

A trust in the child’s name is another option for parents. However, these plans come with legal and administrative fees parents won’t face with a Roth IRA.

Common mistakes

Meanwhile, some parents may believe that it makes more sense not to save at all for their child’s future. The idea is that having no college savings also means having no assets to assess.

However, that strategy may not work because even if parents don’t save anything, they’re still going to have an expected contribution once they fill out the FAFSA (Free Application for Federal Student Aid) form.

Another common error is for parents to save for their children’s future before addressing their own long-term financial circumstances.

After all, most parents don’t expect their children to finance their retirement.

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