Education funding: new tax structure for custodial accounts

By William Creekbaum

President Bush recently signed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) into law, creating many new opportunities and unexpected challenges for individuals saving for a child's education.

One of the unexpected provisions of the act is the expansion of the taxes levied on certain custodial accounts (UGMA or UTMA) for minors. Effective immediately, the act expands the reach of the "Kiddie" Tax by making it applicable to children under the age of 18 (rather than under age 14). The new law affects the taxation of a minor's unearned income above $1,700, which is taxed at the parents' highest income tax rate instead of at the child's presumably lower rate. The purpose of the new rule is to prevent parents from shifting unearned income to children who are in lower income tax brackets.

This increase makes custodial accounts a less attractive way to save for college education and other long-term expenses. The new provision applies to taxable years beginning after Dec. 31, 2005, so if you have incurred capital gains within a custodial account since Jan. 1, 2006, you will be subject to the new higher tax rates.

Here's what you may want to consider:

The new law boosts 529 College Savings Accounts as the preferred choice for college savings. Funds within a state-sponsored 529 plan grow tax-free and if used for qualified college expenses, the funds come out of the account tax-free as well (through 2010). Many states also offer state tax deductions for contributions to a 529 plan.

If you are concerned with preserving your child's potential financial aid eligibility, consider moving the funds in the child's custodial account into a Custodial 529 plan. As of July 1, UGMA/UTMA assets held within a Custodial 529 savings plan may have advantages if applying for financial aid for college.

Another tax-free savings option for funding qualified college expenses is the Coverdell Education Savings Account. However, the annual contribution limit on a Coverdell is only $2,000 and the Adjusted Gross Income (AGI) phase out limit for contribution eligibility begins at $95,000 for single filers or $190,000 for married filers.

If you have custodial accounts set up for minors or are thinking of gifting appreciated securities to these accounts, be sure talk with your financial and tax advisors about how your family's total tax liability might be affected by the new legislation. Your financial advisor can also help identify more tax-efficient ways for you to save for a child's college education. For information, e-mail me at william.a.creekbaum@smithbarney.com or call 689-8704.

Smith Barney does not provide tax and or legal advice. Please consult your tax and or legal advisors for such advice.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada.