With the costs of college tuition increasing at a rate greater than inflation each year, many parents and grandparents want advice on the best way to prepare for future college expenses.

This two-part series will focus on four methods of paying for college and the tax efficiency of each method:

(1) direct payment of tuition expenses
(2) custodial accounts
(3) 529 accounts; and
(4) irrevocable trusts. 

Method 1: Direct Payment of Tuition Expenses

The simplest, most flexible method of paying for college is for parents and grandparents to pay tuition costs directly to the school. 

There is an exemption to the federal gift tax for direct payments of tuition. However, the parent or grandparent must pay the school directly to be eligible for this exemption. Payments made to the student do not qualify, even if they are reimbursements for a legitimate tuition expense.

Payments of other related costs, such as room and board, books and school activity fees, are subject to the federal gift and/or generation-skipping transfer (GST) tax, except in cases where state law requires a parent to make these payments.

Before writing a check for college expenses, it is important that you make sure that the educational institution is the payee and the invoice is for tuition only. Planning to pay the school directly allows parents and grandparents to keep college funds in their names until the bills are due. Meanwhile, they retain complete control over investments and are free to change their minds and use the money for other purposes.

On the other hand, retaining assets in the parent’s or grandparent’s name means investment earnings are subject to income taxes at their rate and subject to claims by the parent’s or grandparent’s creditors, including ex-spouses. If the parent or grandparent dies before the child’s college years, assets in the parent’s or grandparent’s name will be subject to estate tax in his or her estate. 

Method 2: UTMA/UGMA Custodial Accounts

The Uniform Transfers to Minors Act (UTMA) allows custodial accounts to be created for minor children.  Every state has adopted it, except South Carolina, which follows the similar but older Uniform Gifts to Minors Act (UGMA). UTMA/UGMA accounts are simple to create and do not require a lawyer to draft a trust agreement. 

Typically, the UTMA/UGMA account custodian is an adult friend or family member who will not make gifts to the account in order to avoid adverse tax consequences if the donor dies while the child is a minor. The custodian has complete control over the account’s investments and distributions until the child reaches the age specified in the state’s UTMA/UGMA law – usually 18 or 21. (This age varies from state to state; some states, including Pennsylvania and California, allow the donor to designate an age up to 25 years.)

Distributions may only be made for the child’s benefit, such as education, support and medical needs. Once the child reaches the specified age, the custodian must transfer legal title to him or her, and the child may use the assets as desired. Account assets cannot be taken back or shifted to another child, and over time, even a modest account can reach a size that may not be appropriate for a child about to turn 18 or 21.

The child is considered the account’s true owner so account earnings will not affect parents’ and grandparents’ income taxes, and account assets will not be included in their estates upon death (assuming they are not the custodians). However, since the child is considered the UTMA/UGMA owner, the so-called “kiddie tax” may require investment earnings to be taxed at the parent’s rate until the child reaches age 19 (or 24 if he or she is a full-time, dependent student). 

Gifts to custodial accounts qualify for the federal gift tax annual exclusion (see sidebar). Thus, a parent or grandparent can pay tuition directly to the school and also make an annual exclusion gift to the student that same year without triggering any federal gift tax. Finally, assets in a child’s name, including UTMA/UGMA accounts, carry more weight in financial aid calculations than assets in a parent’s name. Thus, if maximizing financial aid is a concern, a UTMA/UGMA account may not be the best vehicle for paying college expenses. 

The Takeaways:
1. Paying college costs directly is the simplest method of paying for college, but retaining assets in the parent’s or grandparent’s name means investment earnings are subject to income taxes at their rate and are subject to claims by the parent’s or grandparent’s creditors.

2. Before writing a check for college expenses, make sure that the educational institution is the payee and the invoice is for tuition only.

3. A UTMA’s assets cannot be taken back or shifted to another child, and over time, even a modest account can reach a size that may not be appropriate for a child about to turn 18 or 21.

Read Part 2 in this series to learn more about the role of 529 accounts and irrevocable trusts in paying for college expenses tax efficiently.

See the complete lineup of articles in ThinkAdvisor’s 23 Days of Tax Planning Advice: 2016.