The Pillars of Education Planning

The Pillars of Education Planning

An ever-stressful topic among parents is how to accumulate sufficient resources to meet their children's education funding needs. Ideally, the accumulation of resources for education costs should be based on an investment strategy that incorporates fundamental investment planning principles. Before an investment strategy is formulated a parent may wish to address three basic issues that may be critical to successful planning:
  1. control of investment assets,
  2. financial aid concerns, and
  3. taxation of investments transferred into child's name.
A sound first step is to address the question of who wants control of the assets. If the parent is not comfortable with giving up control of the investment assets that are going to be put aside for their child's education, the investment assets should remain in the parent's ownership. This may cause the investment assets to be taxed at the parent's higher marginal tax rate, but the parent is keeping control of the assets and this may be what is most important. If, on the other hand, the parent has no reservations transferring assets into their child's name, then this can be easily accomplished by utilizing an UGMA/UTMA account. This, of course, comes with the understanding that if their child fails to go to college and instead wishes to become an avid European back-packer, it is the child's money and he/she can do with it as he/she wishes upon reaching the age of majority. Remember that all transfers (gifts) to a child via an UGMA/UTMA account are irrevocable and the parent needs to be aware this really does mean non-changeable.

Second, a parent with a college bound child intending to seek financial aid should consider how assets owned by the child may be treated by colleges and universities during the financial aid needs review. Typically, 35% of assets held in the child's name may be deemed available to meet education expenses while 5% to 6% of the same assets may be deemed available if owned by the parent. The net effect may be potentially less financial aid for the child and, indirectly, the parent if assets are held in the child's name.

Finally, the decision to transfer assets into the child's name should be based upon a good understanding of the ?Kiddie Tax? rules and to what extent the parent may derive tax benefits. For children under age 14, the first $750 of unearned income is tax-free, and the next $750 is taxed at the child's rate which is most often 15%. All investment income over $1,500 (for 2001) is taxed at the parent's marginal tax rate, assuming the parent's rate is higher than the child's rate. The age cap of 14 on the ?Kiddie Tax? may allow for some potential tax savings depending on the amount of assets the parent is going to transfer into the child's name. For example, if the assets transferred to the child's name generates $1,500 in investment income or less per year the resulting tax burden assessed will be at an effective rate of 7.5%. If the investment income exceeds $1,500, all additional income will be taxed at the parent's marginal tax rate that could be as high as 39.1%.

Beginning in the year the child turns 14, however, the child's unearned income is taxed at the child's rate. Thus, a strategy to shift unearned income to the child beginning in the year the child turns 14 to take advantage of what might be as much as a 24.1% tax bracket differential (39.1% vs. 15%) may be a prudent and beneficial decision. Also, with recent tax law changes, the differential for long-term capital gains is now 10% vs. 20% for most children 14 years or older compared to 15% vs. 27.5%. From a practical standpoint, with the child reaching the age of 14, the parent will start to get a good indication of what type of child they have, studious or European back-packer, and may be more comfortable in making the decision to transfer assets at this point.

Having an understanding of the "pillars of education planning" provides for a solid foundation from which to analyze education-funding decisions. Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this goal in light of your unique personal circumstance. Before implementing an education planning strategy, contact and consult with your financial advisor.