A New Tax Puts Your Kid's College Fund Up in the Air
The rules have changed. Time for new tactics.
(MONEY Magazine) – Are you saving for your child's college education in a custodial account? Uh-oh. Congress has changed the rules. Under the old law, investment income earned by kids 14 and older was taxed at their rate, not their parents' usually higher one. But this year kids up to age 18 will pay at their parents' rate on amounts over $1,700. The result is a potentially bigger tax bill, especially on accounts in the mid-five-figure range or higher. So, what to do?
• Switch to a 529. Earnings in a 529 are tax-free if the money is used for education. (This break is due to expire in 2010 but is likely to be renewed.) One hitch: You can't transfer money from a custodial account directly into a 529. You must first cash it out, which may incur capital-gains taxes.
• Or consider a Coverdell. Earnings in these accounts are also tax-free if the money is used for education. The contribution limit is only $2,000 a year, however, and for the account to be fully funded, your income must be under $190,000. As with a 529 plan, you'll have to liquidate your custodial account first.
• Spend it down. If the cost of cashing out your custodial account is too high, consider spending it down in ways that will benefit your child--say, on SAT tutoring or an afterschool program. Then stash the money you would have spent out of your own pocket on these programs in a 529 or Coverdell.
• Be tax-wise. If you stick with your custodial account, gradually move into growth stocks, munis and other investments that might help hold taxable income under $1,700. And try to delay tapping the account until your child turns 18, when his lower tax rate will again apply.