Section 529 plans are all the rage for college savings. But you might be inclined to go against the grain. You might prefer more investment options or feel hampered by state-imposed restrictions.
Other options, such as custodial accounts, are still available. But you can do better by borrowing an idea from the estate-planning playbook.
Strategy: Set up a “Crummey trust” for a college-bound beneficiary. This arrangement offers greater protection than a custodial account with the same tax advantages.
Traditionally, a Crummey trust (named for the landmark court case authorizing its use) transfers assets to the younger generation without triggering estate and gift taxes. But it also can work as a college-savings tool.
Here’s the drill: As with a custodial account, you transfer funds to a trust account over time. You name the child as the beneficiary, and you can act as the trustee, directing the investments.
So far, so good. But a potential problem exists: Any amounts transferred to a custodial account become the beneficiary’s legal property when he or she reaches the age of majority in the state where you live (generally 18 or 21). So your child can blow all the cash on a luxury sports car or a trip around the world instead of using it for college tuition.
On the other hand, if you impose restrictions on your child’s right to access the funds (e.g., prohibiting withdrawals until age 25), the transfers to a trust generally aren’t eligible for the annual gift-tax exclusion. Currently, you can give away up to $12,000 a year to a recipient without any gift-tax liability ($24,000 for joint gifts made by a married couple).
Solution: For each year in which you transfer funds to the trust, provide a brief “window of opportunity” for the child to withdraw funds. The window, which can be as short as 30 days, applies only to the funds transferred in that year. The balance remains off-limits.
Usually, the 30-day period comes and goes without any withdrawals. In any event, the window enables the transfers to qualify for the annual gift-tax exclusion.
Best of all, if your child doesn’t go to college, you can keep the money in the Crummey trust until the time you deem appropriate. For example, you might authorize withdrawals of 50% of the account at age 30 and the remainder at age 40, with exceptions for specified expenses such as medical bills. In short, you call the shots.
What about income tax? The IRS taxes the trust’s earnings at your child’s low tax rate. But be aware that the kiddie tax applies to investment income above a specified limit until the year during which the child reaches age 18.
Tip: Consider using the services of a tax pro.
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