New college terms and the accompanying bills for tuition, room and board, plus books and other expenses of keeping one or more children in school lead parents to thinking about accumulating college funds free of income taxes. At least two general plans can be used separately or together.
Giving your children income-producing assets to finance their schooling several years before they register transfers the assets and interest income to them. Gifts of stock, bonds, certificates of deposit -- even notes -- transfers income to minors. If youngsters have little or no outside income of their own, all of the interest or dividend income accrues to them. If their total income is less than $1,000, no federal income tax return is required. Even though a return is filed, all of the income is tax free up to $2,300 or more. This compounding rate makes a substantial difference on accumulations. For example, at a 12-percent rate, an initial investment will double in six years. But, if tax is taken out of income to reduce the after-tax rate to 8 percent, the initial investment requires nine years to double. A 50-percent marginal tax rate doubles the time necessary for an initial investment to increase 100 percent in value.
Gifts to minors may be accomplished under Uniform Gifts to Minors regulations whereby securities belong to the minor but are managed by a custodian. The adult custodian should not be a parent if an alternative is viable. Otherwise, assets in a minor's name are swept up in the estate of a parent who dies before the youngster achieves majority.
Each parent may give up to $3,000 a year to any number of children without filing a gift tax return or paying a gift tax. Thus, two parents may give up to year. Since the income escapes tax until the minor earns substantial income, high-yield securities such as utility income stocks or shares in gold mining companies can be used effectively to build a college fund.
Gifts to minors are irrevocable, and income may not be used for normal support of the children. Further, the gifts may not have strings attached. If the children decide not to use their funds to attend college, parents may not get the cash or assets back.
A second method is more complicated and is applicable mainly to parents owning substantial assets. A short-term or Clifford trust may be established by transferring income-producing assets to it. The trust must extend for a minimum of 10 years. An attorney should draw up the trust, and it can be managed by a friend. Although the assets in the trust draw interest or other income for the benefit of minors, the assets revert back to the parents at the discontinuance of the trust. Only the income from trust assets goes to the children. As long as the children's income is below $1,000, no return is necessary, and much more income may be earned from the assets before income taxes are due. Thus, the trust fund compounds tax free for much of the 10 years before children begin college. After a minimum of 10 years the trust may be terminated; the children, now adults, take over the income earned by the trust, and the original assets revert to the parents.