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Tax Savings from Child Asset Ownership

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Whether an account is owned by the child or a parent can affect the amount of income taxes due on the account's earnings. It is worth considering the tax impact of who owns the account since this can have financial implications for the overall return on investment.

Child Tax Liability

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Children do not pay taxes on the first $950 in annual income (2010), due to the standard deduction. Subsequent income is taxed at either the child's rate or the parents' rate:

  • If the child's earned income exceeds one-half of their support, the tax rate is based on whether the child reached age 18 as of the end of the tax year.
    • Before a child reaches age 18, the next $950 in income is taxed at the child's rate. Earnings above $1,900 are taxed at the parent's marginal rate.
    • All income (after the first $950) earned by children age 18 and older is taxed at the child's rate.

  • If the child's earned income does not exceed one-half of their support, the tax rate is based on whether the child reached age 19 (24 for full-time students) as of December 31 of the calendar year in which the taxable year of the taxpayer begins.
    • Before a child reaches age 19 (24 for full-time students), the next $950 in income is taxed at the child's rate. Earnings above $1,900 are taxed at the parent's marginal rate.
    • All income (after the first $950) earned by children age 19 and older (24 for full-time students) is taxed at the child's rate.
This is often referred to as the "Kiddie Tax".

The taxes are on all income, including unearned income such as interest, dividends, and capital gains.

Strategies for Minimizing Taxes vs Maximizing Aid

The bottom line is that parents who expect to receive need-based financial aid for college should not save money for college in the child's name. The loss of aid eligibility outweighs the minimal tax savings gained through the child's lower tax bracket. This is especially true now that Congress increased the age threshold from 14 to 18 or 19 (or 24 if a full-time student).

Since the child typically pays taxes in a lower tax bracket than the parents, a common tax-sheltering technique is to shift income-producing assets to the children. The difference in tax brackets can lead to significant income tax savings.

Specifically, the Uniform Gift to Minors Act lets each parent give each child up to $13,000 a year without incurring gift taxes. Thus the parents together may give each child $26,000 a year. The child's tax rate is typically 10% (previously 15%). The other tax brackets are 27%, 30%, 35%, and 38.6% (previously 28%, 31%, 36%, and 39.6%). [These rates dropped to 26%, 29%, 34% and 37.6% in 2004, and to 25%, 28%, 33% and 35% in 2006.] Thus the difference between the parent and child tax brackets ranges from 15% to 28.6% (previously, 13% to 24.6%). For the sake of the discussion below, we will use the old rates, since the new rates may revert after the Tax Relief Act of 2001 sunsets on December 31, 2010. The difference in the tax savings is relatively small.

Many families establish UTMA/UGMA custodial accounts to save for their children's education, taking advantage of the tax savings.

Unfortunately, when the child enrolls in college, his or her assets are assessed by the need analysis formulas at 20%, while his or her parent's assets are assessed at a maximum rate of 5.64%. (The parent assets are assessed at 12%, yielding part of the adjusted available income, which is then assessed at rates of up to 47%. 47% of 12% is 5.64%.) A portion of the parent assets are sheltered as well. (The asset protection allowance depends on the age of the older parent. For most families with college-age children, the asset protection allowance will be around $45,000.) Thus the family loses at least 14.36% a year in financial need assessments.

As a consequence, the reduction in need-based financial aid is much greater than the potential tax savings. Families need to consider this carefully when choosing how to save money for college. In most cases the family is better off using a savings vehicle that financial aid considers to be a parent asset instead of one that is considered a child asset.

If a family expects that they will not qualify for need-based aid, they can use the savings vehicle that shelters the money from taxes without consideration for the impact on financial aid. However, most families do not correctly assess their ability to qualify for financial aid. It is very common for a family to mistakenly believe that they don't qualify when they actually do. The financial aid formulas are extremely complex, and there are many circumstances in which even a high income family can receive financial aid. For example, having multiple children in college at the same time can substantially increase financial aid eligibility. Even some families earning $100,000 or more a year qualify for the Pell Grant for this reason. (According to the 1999-2000 National Postsecondary Student Aid Study, 44.4% of students receive grants, with 28.7% of dependent students with family incomes above $100,000 receiving grants. 23.1% of students receive Pell Grants, with 0.4% of dependent students with family incomes above $100,000 receiving Pell Grants.) So it is important to check whether you will qualify for aid before assuming that you won't.

Just because you didn't qualify for aid when you went to college doesn't mean your children won't. College costs have increased substantially since then. Your friends, neighbors and colleagues might be well-meaning when they give you advice, but they aren't familiar with your finances or with the thousands of regulations governing financial aid. Even if they put a child through college recently, financial aid rules and programs change every year. Their three-year-old information is too old to be useful. Even one-year-old information is likely to be inaccurate. The only way to tell whether you qualify for financial aid is to apply, and you should apply every year even if you didn't receive any aid last year.

The financial aid assessment outweighs any accumulated tax savings because the tax savings were limited to just the income earned by the asset, while the need analysis assessment affects the asset itself. Putting money in the child's name would be a bad deal even if the child didn't have to pay any taxes on his or her income.

Example Comparing Tax Savings with Student Aid Impact

For example, let's assume that there is $10,000 in the college fund, and that this fund earns a 10% annual return for each of the four years before entering college.

First let's consider a family in a 28% tax bracket.

4 yearsChild's NameParents' Name
Initial Investment$10,000.00$10,000.00
After Tax Return$13,858.59$13,206.24
After Need Analysis$11,086.87$12,461.41

Since this family might qualify for financial aid, the extra $2,026.89 in aid eligibility obtained by putting the money in the parents' name is more important than the loss of $652.35 in tax savings. The net savings is $1,374.54.

Now let's consider a family in a 39.6% tax bracket.

4 yearsChild's NameParents' Name
Initial Investment$10,000.00$10,000.00
After Tax Return$13,858.59$12,643.84
After Need Analysis$11,086.87$11,930.72

The family gets an extra $2,058.61 in aid eligibility by putting the money in the parents' name. This savings is offset by a loss of $1,214.75 in tax savings, for a net savings of $843.86. This assumes, of course, that the family will qualify for financial aid. But a family in a 39.6% tax bracket earns more than $288,350 a year (2000 tax tables), and so is very unlikely to qualify for financial aid. Such a family should forgo the decrease in EFC and focus on the tax savings.

Now consider the same families investing $10,000 for 18 years.

18 yearsChild's Name28% Bracket
Parents' Name
39.6% Bracket
Parents' Name
Initial Investment$10,000.00$10,000.00$10,000.00
After Tax Return$42,450.50$34,954.75$28,737.89
After Need Analysis$33,960.40$32,983.30$27,117.07

So in this case, a family in a 39.6% tax bracket has a greater net savings by putting the money in the child's name. But such a family probably doesn't qualify for financial aid, and so should put the money in the child's name regardless of the increased aid eligibility.

Please note that these figures are a gross simplification. They assume that the family is taking capital gains every year. Moreover, they focus only on the first year's need analysis. If the money is left in the child's account, the impact on aid eligibility over the four years of college could be even worse, with 20% being assessed every year!

The bottom line is if a family expects to be eligible for any financial aid, they should not place assets in the child's name. On the other hand, if they are completely certain that they will not qualify for financial aid, they should take advantage of the tax savings. But parents should very carefully assess whether or not they will qualify for financial aid, since many families assume that they won't qualify when in fact they do. Many families in a 31% tax bracket will qualify, and even a few in a 36% tax bracket might qualify, if they have many children in school at the same time.

How to Fix Financial Aid Treatment of Child Assets

If the parents saved for college in the child's name, there are two approaches to minimizing the negative impact on financial aid eligibility:

  • Liquidate the UGMA and UTMA accounts and invest the proceeds in a custodial 529 college savings plan, custodial Prepaid Tuition Plan, or custodial Coverdell Education Savings Account. Due to a legislative drafting error in the Higher Education Reconciliation Act of 2005, such custodial qualified tuition plans were disregarded as assets on the FAFSA from July 1, 2006 through June 30, 2009. Effective July 1, 2009, the College Cost Reduction and Access Act of 2007 corrected the error. Starting in the 2009-2010 academic year, custodial plans owned by a dependent student will be treated as though they are a parent asset on the FAFSA. This will yield a more favorable financial aid treatment.

  • Transfer the money from the child's name back to the parent's name. Usually this is accomplished by spending the child's money for the benefit of the child on nonparental obligations (e.g., a laptop, summer camp or other existing expenses) while saving a similar amount of money in the parents' names. Otherwise there would be tax implications, plus it might be considered a breach of the parents' fiduciary duty to the child, as money in a custodial account is legally the child's.

Legislative History

Effective January 1, 2008, the age threshold increased from age 18 to 19 (24 for full-time students) for children whose earned income does not exceed one-half of their support. The new age thresholds are based on section 152(c)(3)(A) of the Internal Revenue Code, which indicates that the new age thresholds are relative to the end of "the calendar year in which the taxable year of the taxpayer begins". (This is a change from the age 18 threshold, which was relative to the end of the tax year. It only applies to children who have reached age 18 by the end of the tax year.) In other words, the age threshold is reached when the child has their 19th birthday (24th in the case of a full-time student) by December 31 of the tax year. This roughly aligns the kiddie tax with the definition of an independent student in section 480(d)(1) of the Higher Education Act of 1965, which defines an independent student as "24 years of age or older by December 31 of the award year".

Section 510 of the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222), signed into law by the President on May 17, 2006, increased the age from 14 to 18. Section 8241 of the Small Business and Work Opportunity Act of 2007, which was included in the U.S. Troop Readiness, Veterans' Care, Katrina Recovery, and Iraq Accountability Appropriations Act of 2007 (P.L. 110-28), increased the age threshold from 18 to 19 (24 for full-time students). This legislation was signed into law by the President on May 25, 2007 and went into effect for the tax year following enactment.

The increases in the age threshold for the Kiddie Tax significantly reduced the benefit of saving money for college in the child's name.

 

 
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