If you have young children or grandchildren, you have several options for saving on their behalf.
One option is to put the money in the child’s name through a custodial account. If you contribute $5,000 a year to a custodial account for a three-year-old and earn an annual after-tax rate of 8 percent, the account will grow to about $200,000 in 18 years. Generally, you would be required to distribute all the money in the account to the child at age 21. Do you really want to hand over $200,000 to a 21-year-old?
What’s more, a custodial account with $200,000 might generate $6,000 or $8,000 or more in income. Under current law, youngsters’ investment income over $1,700 is taxed at the parents’ rate. So there may be little tax benefit in building up a large custodial account.
A better option is to invest the money in a 529 college savings account, offered by most states. With a 529 account, there would be no income tax on any earnings inside the account.
Distributions also can be tax-free, if an equal amount is spent on qualified higher education expenses at an eligible institution. If the money in a 529 account is not needed for college, you can withdraw the funds and pay tax plus a 10 percent penalty on the investment income.
You might also put some of your college money into a tax-managed mutual fund, offered by major mutual fund companies. These funds hold stocks, so investors have the potential for stock market gains. As the name suggests, fund managers handle trading so that investors don’t have to pay taxes each year, as long as they hold onto their shares in the fund.
If you invest college money in a tax-managed fund, you can keep the account in your own name. The money won’t be turned over to the youngster when he or she comes of age, as early as 18 in some states. Instead, you remain in control.
When the children are ready to go to college, you can sell shares of this fund to raise money. If the shares have gone up in price, so tax will be owed, you can first give your shares to the student, who probably will be in a low tax bracket. Then he or she can sell the shares, pay tax at a low rate, and use the net sales proceeds to pay for higher education.