When the Bills Come Due
Tread mighty carefully when tapping your college savings accounts
It's a message that has been drummed into parents' heads for years: Take full advantage of any and every type of investment account you can--especially tax-advantaged ones--to save for your children's enormous college bills.
Clearly, the message has sunk in. A majority of families are now saving for college using at least two different types of investment vehicles. And 1 in 8 households is using three or more different types of plans.
Often, this mix includes old-fashioned custodial accounts, such as Uniform Gifts to Minors Act (UGMA) accounts, alongside tax-deferred education programs like 529 savings plans or Coverdell Education Savings Accounts (ESA s). Still other households are investing in a combination of tax-advantaged plans and taxable brokerage accounts.
But here's the scary part: After spending several years trying to decode the alphabet soup of UGMA s, ESA s, IRA s, and 529s to figure out which plans to invest in, parents face the equally confusing task of determining how to withdraw money from those accounts once the children start college. "This is when things start to get really complicated," says Raymond Loewe, founder and president of College Money, a New Jersey-based college financial planning practice. Even for those who have been saving in just a few different accounts, determining how to draw down those savings isn't always cut and dried. The decision could determine how much financial aid a child is eligible for, as well as affect how much a parent pays in taxes.
Aid considerations are a big reason many planners recommend that parents who have traditional custodial accounts like UGMA s deplete those first to pay for the initial batch of college bills. That's because money saved in a custodial account is held in the child's name to take advantage of the kid's lower tax bracket. And anything in a child's name is worse from an aid standpoint than assets held in a parent's name (colleges will assume that 35 percent of the student's assets can be used to pay for school, versus up to 5.6 percent of the parental assets).
Since "UGMA money hurts your financial aid eligibility, it makes sense to get rid of it first," says College Money's Loewe. That way, once you exhaust those assets early on, you may be eligible for aid by the time your child reaches his or her junior and senior years.
But even if you are not banking on aid, there's a good reason to tap the UGMA first, experts say. Money in those accounts is legally the property of your children. And once they hit the age of majority (typically 18 or 21), they can do with it whatever they wish--including backpacking across Europe rather than paying for a semester's worth of room and board. "Before they wise up to this fact and buy that Corvette, it may be wise to use the UGMA for college expenses," says Gail Fialkow, a financial planner with Capital Planning & Investments in Fairfax, Va.
Prepaid pitfalls. Financial aid is also the reason planners say parents who have purchased credits through prepaid tuition programs--many of which allow families to lock in tomorrow's tuition at today's prices--should use them up before tapping 529 savings plans or Coverdell ESA s. Prepaid tuition credits are extremely detrimental when it comes to financial aid, reducing a student's aid eligibility dollar for dollar. Also, most state-run prepaid tuition plans--along with the so-called Independent 529 plan, which is sponsored by a nonprofit organization representing hundreds of private universities--allow families to prepay only tuition and mandatory fees. So, if you have a combination of UGMA s and prepaid tuition credits, consider using the prepaid assets for actual tuition costs and student fees while using the UGMA for room, board, and textbooks.
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