This post is the first of several related to saving for your children’s education. Subsequent posts will cover how much to save and in what type(s) of account(s) to invest.
A reader asked me if he should invest money in his minor child’s name. Whether it is beneficial or not to save money in your child’s name depends on whether or not you expect to need financial aid for your child to attend college.
It is likely that most parents who are forward thinking enough to consider saving for their children expect their children to attend college. Except for very wealthy families, financial aid for college is an option most will want to keep open. Because assets in a child’s name can reduce the amount of financial aid for which that child will be eligible, for most families it is not a good idea to save in a minor child’s name.
Here are the details. The lure of saving money in your child’s name is the tax advantage it offers. Under certain circumstances, a portion of unearned income (e.g. income from anything other than wages) claimed by your child is taxed at your child’s tax rate rather than your own. At most this applies to the first $1,900 (for 2009) of your child’s unearned income. After that, the “kiddie tax” kicks in and your child’s unearned income is effectively taxed at your income tax rate (i.e. there is no tax advantage). For the purposes of the kiddie tax, a “kid” is a child under 19 or under 24 if a dependent, full-time student.
Sounds like folks with kids could orchestrate a tax break on $1,900 worth of investment income, right? That’s true, but it may not be worth it. The reason is that assets in a child’s name are assessed differently for college financial aid than those in a parent’s name. When applying for financial aid a calculation is done to determine your “expected family contribution” (EFC). Assets in a child’s name are assessed for EFC purposes at a rate of 20% while those in a parent’s name are assessed at a top rate of 5.64%. That’s a huge difference!
If you want to keep your financial aid options as open as possible you want your EFC to be as low as you can make it. You’re always permitted to contribute more than the EFC but you can’t contribute less. So, putting assets in your child’s name locks you into a much higher EFC and much lower financial aid.
There are other reasons not to put assets in your child’s name. First, doing so in a way that takes advantage of the child’s lower tax rate is irrevocable. The assets are the child’s. Moreover, when the child attains the age of majority (which can vary depending on what type of custodial account is set up), she may use them in any way she likes. There is no guarantee they will be spent on college.
There is one good reason I can think of to give some assets to your child: pedagogy. Your child is unlikely to learn much about personal finance and investing in school. If your child demonstrates sufficient maturity as a minor it is worth teaching her how to manage investments. This does not require a large donation and, of course, it is even better if the child invests some of her own money.
For more about setting up accounts for your child, to teach her about investing or otherwise, see The Motley Fool article Investing for Your Kids. I think it covers all of the important issues, but some the kiddie tax rules have changed since it was written. So, check the details on those at IRS.gov.