Darcy Houghton: Beware of college-savings pitfalls

At a recent estate-planning council meeting, participants were discussing the best ways to save for college. Not surprisingly, some of the best college savings plans also had some negative impact on financial aid and income taxation and even added some estate-planning challenges. A short review of the plans follows:

529 Plans: The state has a great prepaid-tuition plan that allows the buyer of the plan to pay for college today at today’s prices and receive the college education in the future. Because tuition costs are increasing so quickly, this plan has some unmatched appreciation benefits. And, for this amazing benefit there are some limitations that should be understood prior to enrolling. The Nevada-sponsored UPromise plan allows Nevada low-income savers a match on the first $300 of plan savings. Residents may enroll in any state’s 529 Plan, although another Nevada-sponsored plan was recently listed as one of the nation’s best plans. All 529 Plans appreciate income tax-free. Another great thing about 529 Plans is that they have a minimal negative impact on financial aid, as they are not treated as an asset of the student and qualified withdrawals are not treated as student or parent income. Non-qualified withdrawals are subject to income tax and a 10 percent penalty. If the plan is owned by a grandparent, there is no impact on financial aid, but … if that grandparent then encounters a long-term-care need, the asset is a countable resource when the grandparent may be trying to qualify for Medicaid. Knowing when to transfer ownership of the 529 Plan from a grandparent to a parent is something that should be discussed with your estate planning professional.

Trust funds: Trust funds create a dilemma. While valuable from a legacy and estate tax perspective, they are generally problematic from a financial aid perspective. Student trust funds are counted as assets fully available to the student regardless of the trust language. Parent trust funds are similarly attributed to the parent. Financial aid goes so far as to look at the net present value of future income and assets. Very specific drafting or requiring a court confirmation for a minor’s trust may have some benefit; however, this should be carefully considered when working with your attorney. While not great for financial aid, grandchildren’s trusts are still a strong tool for encouraging wealth preservation by younger heirs.

UGMA/UTMA/custodial accounts/savings accounts/U.S. Savings Bonds: For financial aid purposes, all of these in the student’s name are considered an asset of the student and any income received from them is treated as income to the student, thus these assets have a high negative impact on financial aid. Additionally, these are traditionally those assets that start out low in value, but can grow to a large amount by the time they are distributed — with no restrictions on how they should be spent at a time when young heirs are exploring their independence. And, adding insult to injury, these assets are taxed to the child at kiddie-tax rates, although the first $1000 per year in income is exempt.

IRS/Roth IRA/401(k)/life insurance: These assets have a low impact on financial aid (they are not counted as an asset on the FAFSA) and grow tax free, but distributions will have varying income tax impacts depending on the age and specific purpose of the person withdrawing funds and how long the assets have been invested. The huge benefit to these savings plans is, if the child does not attend college, their foundational purpose as a retirement plan is still intact and the assets can continue to grow tax-free and be withdrawn at retirement.

As parents and grandparents, it is always a challenge to balance the desire to pass a legacy to our descendants with the income tax and financial aid consequences. Fortunately, our community has excellent advisors who know all the ins and outs of these programs and hopefully know your long-term plan and can help you weave through this maze.

Darcy Houghton of Carson City accepts cases in estate planning and business law. She may be reached at 775-882-1777, or visit her website at www.hou2plan.com.