For those few forward-looking parents eager to set aside income for educating their children, the income tax laws continue to provide a bonus. And a substantial bonus it can be!
I say "few parents" because many seem to prefer the supposed benefit of deducting interest on later loans taken out to finance college educations for children. Buying EE-bonds is one way, but there is a better one.
Saving ahead and putting the money directly into children's names could double funds within a five-year period. Here is the procedure:
Each parent may give to each child up to $3,000 ($10,000 beginning in 1982) each year without filing a gift tax return or paying a gift tax. The cash gifts may be invested in a money market mutual fund, stocks or bonds, or a certificate at a bank or savings-and-loan association, through uniform-gifts-to-minors provisions applicable in all 50 states.
The money is invested by a custodian in the name of each child. The custodian must be an adult and may be a parent. However, if a parent acting as custodian should die before the child reaches majority (18 in some states, 21 in others), the money in the child's name would be included in the parent's estate. Naming a brother, uncle, aunt, or trusted friend to be a custodian is better. Banks, savings-and-loans, and brokers routinely handle custodial accounts for children.
Money once given to a child belongs to the child irrevocably. If he or she decides at majority to take the money and spend it for some purpose other than college, parents may not interfere. The money belongs to the child while a minor and is his to use as desired at majority.
Income from cash given to children and deposited or invested for their benefit cannot be used for their support. That is, the income cannot be used to buy food, clothing, housing, or other such necessities. "Support" is an ill-defined term subject to interpretation.
Once these concerns are understood, the tax savings are beneficial. As long as the income from a child's custodial funds, plus any other income, does not exceed $1,000 for each year, he need not file an income tax return. Cash invested in a money market mutual fund earnings an average of 15 percent would double in five years -- considerably faster than current inflation rates. Thus, after doubling successively three times -- after age 6, 11, and 16. Income on $ 8,000 at 15 percent would amount to $1,200, and $200 could, at present rates, be taxable at 14 percent, depending on any other income rereceived that year. Practically all income on custodial funds would be received tax free, because yearly income would not reach $1,000.
Investment of custodial funds in fixed-income securities, such as money market mutual funds or bonds bought to mature at a specific date when college funds may be needed, could be conservative. Buying stocks could increase the compounding rate even more, but share prices could be in a down cycle when cash is needed to pay for tuition and living expenses. Thus, a variety of investments managed alertly by the custodian could be the best choice for the children.
Even if custodial funds accumulated in children's names are not spent for college, the system offers a means of splitting family income to reduce income taxes. A child with a bankroll of $10,000 to $20,000 at majority would be in a good position to buy a house or start a business -- all with minimum effect on parents' income.