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Hemenway & Barnes AUTHORED LITERATURE
Confused About Your Options to Save For a Child's Education? You Should Be.
Banker & Tradesman,
February 7, 2000
By Dennis R. Delaney
Recent developments have created new choices for saving for a child's
education. When combined with the existing alternatives, a confusing array of
options result. This article reviews many of these options, including the
U.Plan, the U.Fund, Minor's Trusts and UTMAs.
The U.Plan
The U.Plan is a state sponsored college savings program that promotes buying
tomorrow's tuition at today's rates. The U.Plan protects against skyrocketing
tuition costs by guaranteeing to cover the same percentage of tuition and
mandatory fees as the original investment would purchase at the time the donor
deposits funds to the account. Proceeds from a U.Plan account are exempt from
state and (most likely) federal income tax. The U.Plan contains numerous
restrictions, however, which make it a poor choice for many. For example, it
requires the student to attend a participating Massachusetts college or
university, and it generally covers only tuition and mandatory fees, not
supplies or room and board. If the child never attends a participating
university or college, you'll get your investment back with modest interest,
but you could put your money to better use.
The U.Fund
The U.Fund is the other state sponsored college savings plan in Massachusetts.
Although the U.Fund is certainly an improvement over the U.Plan, many may find
a minor's trust or UTMA more attractive (both of which are discussed below).
But first, a brief description of the U.Fund. The U.Fund allows you to set up a
tax deferred investment account for the benefit of any other person and use
the account's funds to pay tuition and most fees and expenses at most colleges
and universities in the United States, as well as at graduate, vocational and
trade schools. Its advantages include deferring federal and Massachusetts
income tax, shifting income from the donor to the child when withdrawals are
made, and allowing the donor to change the beneficiary in many cases with no
adverse tax consequences.
At first glance, the U.Fund sounds like a terrific deal, but further
digging reveals a somewhat muddled picture. For example, the donor has no
control over how to invest the account. Fidelity manages the funds according
to a predetermined formula set by the Massachusetts Education Finance Authority
(MEFA). When the child is young, the investment mix is weighed heavily in favor
of equity funds, with some high-yield bond funds. The portfolio gradually
becomes more conservative until the child reaches age 18. From that point on,
80 percent of the account is held in short-term bond, money market, and fixed
income funds and 20 percent is in equity funds. For some, this may be a
sensible way to handle the investment decisions, but others will find it to be
somewhat draconian. Not everyone, for example, would have wanted 80 percent of
an account invested in fixed income, bond and money market funds these past few
years. Many people would have preferred to have the account in a low-cost index
fund for several years, directly in equities, or even with a mutual fund
company other than Fidelity. This, however, is not an available option for a
U.Fund account, and only MEFA can change the investment formula.
Another factor that donors should consider before setting up a U.Fund
account is its limited flexibility. Only withdrawals for "qualified higher
education expenses" receive favorable tax treatment. All other withdrawals are
hit with a 10 percent penalty and are taxed as income to the donor, not the
child. Thus, for example, if a donor needed access to the funds in a U.Fund
account for a child's unexpected medical expenses, no withdrawal could be made
without incurring the 10 percent penalty and paying income tax on the withdrawn
funds. Moreover, if the child drops out or never attends a qualifying school,
problems may arise. The donor may change the beneficiary, but the new
beneficiary must be related to and in the same generation as the original
beneficiary or the transfer will trigger the gift tax. If the donor has no
other beneficiary he or she wishes to name, the only option is to withdraw the
funds, incur the 10 percent penalty, and report the proceeds on his or her
income tax return. Thus, parents with only one child may want to think twice
before establishing a U.Fund account.
As for other tax consequences, the U.Fund modifies the "annual exclusion"
rules, which normally allow any person to transfer up to $10,000 per year to
any other person without gift or estate tax consequences. A donor may transfer
up to $50,000 to a U.Fund account in a single year with no gift tax consequence,
but again, what appears to be a windfall on the surface is actually somewhat
more complicated. The donor who transfers $50,000 to a U.Fund account is
actually deemed to have allocated five years' worth of annual exclusion to the
transfer. Thus the $50,000 is pro-rated over the next five years, which means
that the donor may not make any additional gifts to that beneficiary or that
beneficiary's U.Fund account for the next five years without triggering the
gift tax. This also means that if the donor dies before the five year period
has passed, the unallocated portion of the transfer will be subject to the
estate tax.
A few final points about the U.Fund are that Fidelity charges an average of
roughly one percent of the value of the account per year for management and
administrative expenses (but there is no charge for establishing a U.Fund
account), and the proceeds of a U.Fund account need not be withdrawn at any
specific age.
Minor's Trust
A minor's trust is a type of trust specifically defined under section 2503 of
the Internal Revenue Code to qualify as a "present interest", which means that
transfers to the trust qualify for the $10,000 annual exclusion from the gift
tax. A donor establishes the trust, opens an investment or bank account in the
name of the trust, and transfers funds to the account. The trustee typically
makes investment decisions. Many donors name their spouse, a sibling or a
professional fiduciary as the trustee so as to ensure that the trust assets
will not be included in the donor's taxable estate upon death.
Unlike the U.Fund, the minors trust can be quite flexible. It may provide
for distribution of the trust's funds for nearly all of the child's needs:
medical, educational, and others. Thus a child who never goes to college but
who starts a business could still benefit from the trust without penalty. A
minor's trust must submit income tax returns and it is taxed at the highest
rate, but income tax consequences can be minimized if the funds are invested
for long-term capital appreciation with low turn-over.
As for gift tax issues, instead of being able to transfer $50,000 to the trust
in the first year and nothing for the following five years, the donor applies
$10,000 of annual exclusion per year so that after five years he has
transferred $50,000 with no gift tax consequence. Unlike the U.Fund, however,
there is no risk that a properly drafted minor's trust will be subject to the
estate tax.
A minor's trust is legally the property of the child and must be distributed
to the child at age 21. However, the beneficiary may elect to continue the
trust to a later age chosen by the donor. This, in fact, is what often occurs.
A minor's trust is more expensive to establish than a U.Fund account, as you
must hire a lawyer to draft the trust. The U.Fund may well have higher expenses
as time goes by, however, depending on whether you hire a professional trustee
to manage the trust assets and what the professional charges for fees.
UTMAs
UTMA stands for "Uniform Transfers to Minors Account." An UTMA is a bank
account or investment account that holds assets for the benefit of a minor,
with the parent normally acting as the custodian. The advantages of an UTMA
are that it costs nothing to set up, is taxed in the child's income tax
bracket (once the child reaches age 14), the custodian retains full investment
control, and the proceeds can be put toward virtually any expense, not just
education (so long as the funds are truly used for the child's benefit). Also,
the donor need not fund an UTMA with cash (which is also true of a minor's
trust but is not true of the U.Fund). This means that the donor can transfer
appreciated securities to an UTMA, thereby deferring the capital gain on
those securities and shifting the gain to the child's bracket.
The principal drawback of an UTMA is that child gets full access to the
account at age 21 and can spend the money however he or she sees fit. Many
people attempt to prevent the child from receiving a windfall at age 21 by
spending the entire account for the child's benefit before that point. Another
drawback is that if the donor serves as custodian, the funds deposited to an
UTMA will be included in the donor's estate should the donor die before the
account is fully distributed. Contributions to an UTMA are not subject to
gift tax so long as they do not exceed the contributor's annual exclusion.
Conclusion
The best choice for you depends on your individual circumstances. Are you
looking just to put away a relatively small amount of money that could be
fully distributed before your child reaches age 21? Do you want to be able
to spend that money for educational as well as other needs your child may
have? If the answer to both of those questions is yes, an UTMA may be the best
choice. If you are certain the funds will only be needed for your child's
education and you have no objection to the investment formula or Fidelity,
the U.Fund may be for you. If you are looking to retain maximum flexibility
to i) hold the funds beyond age 21; ii) use the funds for purposes other than
education; and iii) be free to invest in any type of security, you should
consider setting up a minor's trust. In all cases, you should consult a tax
advisor or estate planning attorney before venturing forward to ensure that
you choose the vehicle best suited to your circumstances.
DENNIS R. DELANEY is a lawyer at the Boston law firm of Hemenway & Barnes,
where he concentrates on matters involving estate planning, probate and
taxation.
Reprinted with permission of Banker & Tradesman. This document may
constitute advertising under the rules of the Supreme Judicial Court of
Massachusetts.
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