529 Accounts Go To Head Of Class

Changes In Tax Law Give The Savings Plans A Boost

(U.S. News & World Report) 
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 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).

By law, a custodial account belongs to the child, so having large amounts of savings in an UGMA or UTMA is detrimental for qualifying for aid. Meanwhile, 529 assets are not considered student money for financial-aid purposes, according to recent federal rulings.

If you've already started saving through an UGMA or UTMA, don't worry. Parents can roll over these accounts into a so-called custodial 529. While the money will still technically belong to the child, the assets will not be counted as student assets for aid purposes, even though the account maintains custodial status, the federal government recently said.

What about prepaid tuition plans, which allow parents to purchase units of future education at today's prices?

Earlier this year, the government gave these college savings vehicles a big boost by improving their financial-aid status. Under the old rules, the value of a prepaid tuition plan would reduce a student's aid eligibility dollar for dollar. But starting in July, the government put prepaids on a level playing field with 529 savings plans. Both savings vehicles are now beneficial for qualifying for aid since they are not considered student assets.

Even if you intend to use a prepaid plan to save for school, though, you will still probably want to start a 529 savings plan, too. That's because prepaid plans are good only for covering tuition and fees. They don't typically cover room and board. And in recent years, room and board has become nearly as expensive as tuition at many schools.

The bottom line, no matter what type of college savings vehicle you now use, is that you probably need to consider opening a 529. "These recent changes," says Joe Hurley, president of Savingforcollege.com, "really made the 529 more attractive relative to all other college savings vehicles out there."