529 Accounts Go to the Head of the Class
Changes in tax law give the savings plans a boost
While the government ignored Coverdells in its most recent tax package, newly passed legislation has actually made yet another college savings option-traditional custodial vehicles like Uniform Gifts to Minors Act accounts (UGMAs) and Uniform Transfers to Minors Act accounts (UTMAs)-much worse.
Before 529s came into existence in 1996, parents often relied on UGMAs and UTMAs to save for college. That's because the custodial accounts allow parents to take advantage of their kids' lower tax bracket. For instance, the first $800 of unearned income for children 13 or younger used to be tax free. The next $800 was taxed at the child's lower rate. And the rest was taxed at the parent's rate-until the kid turned 14, when all the unearned income would be taxed at the child's lower rate. This allowed parents to give appreciated stock to their kids, have the children sell the stock after turning 14, and then use the proceeds to pay for school.
Kiddie-tax change. But in May, Bush signed the Tax Increase Prevention and Reconciliation Act, which changed the kiddie-tax rules. Now, the first $850 of unearned income kids receive will be tax free, the next $850 will be taxed at the child's rate, and the rest will be taxed at the parent's rate until the child turns 18. Since kids now have to wait until their senior year of high school or freshman year of college to take full advantage of their lower tax rate, custodial accounts are far less attractive for parents saving for school. "In my opinion, UGMAs and UTMAs are essentially dead as a college savings tool," says Cal Brown, vice president of planning at the Monitor Group, a wealth management firm in McLean, Va.
A recent analysis by T. Rowe Price seems to back Brown up. Say you put $5,000 a year into a 529 for your daughter, and it earned 8 percent annually through investments in a blue-chip growth stock fund. After 18 years, you would end up with more than $218,000 for her college bills. By using a home-state 529 plan that offers residents a state tax deduction, you'd be likely to amass nearly $224,000, T. Rowe Price found. (Parents can choose any state's 529 plan; information about which plans offer tax breaks is at www.savingforcollege.com.)
Now compare that with what you would save through an UGMA. Under the old rules, a typical parent in the 25 percent federal tax bracket could expect to accrue around $210,000 in the custodial account, according to T. Rowe Price. But under the new rules, you're likely to save even less: $207,700.
Plus, UGMAs and UTMAs are terrible from a financial-aid standpoint. As a rule of thumb, it's always better to save money in the parent's name, since Uncle Sam expects only 5.6 percent of parental assets to be used to cover college expenses. By contrast, the government will assume that 35 percent of the student's money can be used to pay for school (in the 2007-08 school year, this will drop to 20 percent).