Saving For College

Posted by jcmaziquemd on October 2, 2010

Higher Education at a Lower Cost


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The 529 college-savings plan is getting close to college age itself.

Introduced in 1996 as a vehicle for families to save for higher education while protecting investment gains from taxes, the plans have had a mixed record of success.

Now they are causing grandparents some distress, too.

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Mark Matcho


Richard Gallagher, a 78-year-old retired doctor in Santa Rosa, Calif., recently wrote us to ask about using custodial accounts to invest money for his grandchildren versus 529 accounts, which offer a limited number of investment choices. He has three grandsons, ages 16, 15 and 11, and the "small seed money" he put into the custodial accounts to help pay for college has appreciated to $75,000, $70,000 and $33,000.

Dr. Gallagher wants to know whether he should turn over all or part of the custodial accounts to their parents to use as the children enter college, which could mean the family’s incurring taxes when the investments are sold.

Alternatively, he could open 529 accounts for his grandsons now, incurring taxes when the investments are liquidated and reinvested, but from which future earnings and withdrawals used for higher education generally would be tax-free.

One consideration: How would all this affect his grandsons’ eligibility for need-based scholarships or student loans?

The dilemma is a common one for people who began saving for their grandchildren’s education a decade ago using accounts set up under the Uniform Transfer to Minors Act or Uniform Gifts to Minors Act, before a tax-law change made 529 plans more popular, says Glenn McKinney, a financial adviser in Long Beach, Calif.

The first thing Dr. Gallagher needs to figure out is how likely it is that his grandsons would qualify for financial aid. He can go to collegeboard.com, click on "For Parents," then on "Fin. Aid Calculators" and run the "Expected Family Contribution (EFC) Calculator."

If the custodial accounts funded by the grandfather appear likely to disqualify the students from financial aid, "we would recommend planning to try to minimize the impact of those accounts," says Deborah Fox, founder of Fox College Funding in San Diego. Such an account has to be reported as a student’s asset, she says, and up to 25% of its value could count against the student in financial-aid formulas.

Since a much smaller percentage—only 5.64%—of an account registered to a parent alone would count against the student, Ms. Fox recommends moving the assets from the existing custodial accounts to a 529 plan in the parents’ names.

Custodial accounts are counted as an irrevocable gift, so Dr. Gallagher can’t simply liquidate the funds and reinvest them. Instead, he should start paying, on behalf of the student, for things like private-high-school tuition, tutoring, test preparation, a first car—"anything that is not a basic support item," Ms. Fox says.

He could then reimburse himself for those expenses out of the current custodial account, along with any other documented bills he has paid on the student’s behalf since opening the account.

Finally, he could use those reimbursements to contribute to the 529 account that the parents open—since some schools could count withdrawals from a grandparent-owned 529 as a "resource to the student," resulting in a dollar-for-dollar reduction in financial aid, Ms. Fox says. Alternatively, the grandfather could designate himself as the owner of a 529 account and change ownership to one of the parents before the child starts college.

There is another tax advantage to going the 529 route: The money grandparents put into a 529 plan is no longer considered part of their estate. Each grandparent could contribute up to $13,000 a year for each child without incurring gift taxes, or $65,000 in one fell swoop, using up five years’ worth of exemptions at once.

For families too flush to qualify for need-based aid, custodial accounts make more sense, says Julie Schatz, a financial planner in Menlo Park, Calif.—especially for grandparents (or parents) who want to actively manage the investments or can give the child appreciated assets, which may be taxed at the child’s lower rates.

—Email: familyvalue


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