Should you save for a child’s education in your name or theirs?

There are three potential drawbacks to saving money for a child’s education under his or her own name: the kiddie tax, federal financial aid rules, and control issues.

First, the kiddie tax. At one time, saving money for college in a child’s name was recommended because of the tax saving opportunities that resulted when children were taxed at their own rate on all their unearned income. However, Congress partially closed this loophole some years ago with passage of special rules commonly referred to as the “kiddie tax” rules.

Under the kiddie tax rules, a child’s unearned investment income over a certain amount is taxed at trust and estate income tax rates. In 2018, this amount is $2,100 — the first $1,050 is tax free and the next $1,050 is taxed at the child’s rate. The kiddie tax rules significantly reduce the tax savings potential for holding assets in a child’s name.

The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn’t exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support. To lessen the impact of the kiddie tax, choose tax-free or tax-deferred investments in which the annual expected income does not exceed the threshold amount of $2,100.

Second, the federal financial aid rules have a more negative impact on child assets than parent assets. Under the current federal aid formula, a child must contribute 20% of his or her assets to college costs each year, whereas parents must contribute 5.6% of their assets each year. So $10,000 in your child’s bank account would require a $2,000 contribution from your child, but that same $10,000 in your bank account would equal a $560 contribution from you. The more assets a child has, the more he or she will be expected to contribute to education costs, and the less financial aid he or she will be eligible for.

Finally, there is the control issue. Do you want your child to have control over the money in their college savings accounts? For example, some parents open a custodial account (UTMA/UGMA) to save for their child’s education. However, with a custodial account, when the child reaches the age of majority (18 or 21, depending on the state), he or she gets full control over the money in the account and can use the money for anything, not necessarily college. Some parents aren’t willing to relinquish this control to their child.

For all these reasons, it’s generally recommended that parents save for college in their own names, not their children’s names.

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