Tax Savings from Child Asset Ownership
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
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:
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.
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.
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.
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:
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