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Frequently asked questions about college savings

What is an educational investment account (Education IRA)?
The Taxpayer Relief Act of 1997 established a new type of savings account designed to help parents save for their children’s college education. Most taxpayers can now put up to $500 a year into one of these accounts. Although contributions to such an account are not tax-deductible, earnings in the account will accumulate tax free. No taxes will be levied on withdrawals if the money is used to pay education expenses. The full $500 contribution for each beneficiary is available for joint filers whose modified adjusted gross income is less than $150,000 and single filers with modified AGI less than $95,000.

What are the pros and cons of planning ahead and prepaying tuition for a designated college?
Many colleges offer so-called prepaid tuition plans. The typical plan requires that you pay a relatively small sum of money while your child is still young, possibly even before he or she is out of diapers. In exchange, the college guarantees that your youngster’s tuition will be fully paid when it’s time to trot off to school. Many financial experts urge parents to avoid such programs. What happens if your kid doesn’t want to further his education, or simply decides on a different school? Some prepayment plans cover several colleges -- which is a little better -- but that still won’t help if your son or daughter decides that a high school diploma is enough.

Are there any tax issues involved in prepaid college tuition plans?
Some colleges now offer prepaid tuition plans. In a typical plan, you agree to pay a lump sum today and, in exchange, the college will guarantee your child four years of free or low-cost schooling. While such an arrangement can help you beat the high cost of college, earnings on the plan’s investments are tax-deferred. When the plan pays the tuition benefit, the difference between the purchase price and the benefit will be taxed. The good news is that if the funds are used for qualified higher education expenses, the investment earnings will be included as part of the beneficiary’s income; therefore, the earnings will be taxed at the student’s tax rate rather than the purchaser’s tax rate.

What is the Uniform Gift to Minors Act?
The Uniform Gift to Minors Act, or UGMA, is the federal law that allows you to give securities and many other types of investments to your children. Under UGMA, you may place the securities or other assets in a savings plan for a child, but the account must be registered in the child’s name. In a UGMA, an adult (usually a parent or grandparent) serves as custodian and is responsible for investing and managing the assets. But the child is the "beneficial owner," meaning the assets really belong to the child, not to the adult. At age 18 (in most states), control of the assets must be turned over to the child. All states offer UGMAs and many have adopted the Uniform Transfers to Minors Act, or UTMA, as well. The former allows children to own stocks, bonds, mutual funds, and other securities; The latter allows them to also own real estate. Also, under UTMA, you can delay giving the assets to the child until age 21.

Under the Uniform Gift to Minors Act, will my child take control of the money I’ve saved for him when he turns 18?
Generally yes. When you’re saving on behalf of a child, the account must be registered in the child’s name under the Uniform Gift to Minors Act. In an UGMA, an adult (usually a parent or grandparent) serves as the custodian of the account and is responsible for investing and managing the assets. The child, however, is the "beneficial owner" of the assets. They belong to the child, not to you. When your son or daughter turns 18, they can spend the money any way they wish without your permission.

How much can I give in tax-exempt gifts per year?
The Internal Revenue Service allows you to give up to $12,000 a year to anyone without triggering the so-called gift tax. You could give $12,000 to your son, another $12,000 to your daughter, and $12,000 more to each of their spouses every year without having to pay taxes on the gifts.

What are some tax-smart ways of accelerating my giving program to my children?
There are a number of ways to accelerate your gifting program to your children.The Internal Revenue Service allows you to give up to $12,000 to anyone each year without triggering a gift tax. Thus, you could give $12,000 to each of your sons and $12,000 to each of your daughters and still avoid the tax. If you’re married, your spouse can make separate gifts for the same amount, which means each of your kids could get $22,000 a year without triggering any gift tax.

You could also create a family limited partnership, or limited liability company, and make gifts of partnership or member units to your children at deep discounts. Discounts for lack of marketability and minority interest can range from 10% to over 50%. However, the actual valuation discount must be established by a professional valuator.To meet IRS standards, the family limited partnership must have a valid business purpose. The children who become limited partners must have the legal ability to exercise their rights, and capital must be a material part or reason for the income of the partnership.

If my parents pay for my daughter’s schooling, what are the tax implications?
There are two popular tax-favored methods whereby grandparents can help with their grandchildren’s education.The first method is to make a gift under the Uniform Gifts to Minors Act (UGMA). Each grandparent can give up to $12,000 per child annually free of gift tax, which should be placed in a UGMA account in the grandchild’s name, with the parent or grandparent as custodian. As long as the child is younger than age 18, his or her account can generate up to $850 of income per year without taxation. Income from $850 to $1,700 is taxed at the child’s tax rate. Income exceeding $1,700 is taxed at the parent’s highest marginal tax rate.The second option is for the grandparents to purchase Series EE or Series I bonds, or give the money to the grandchild’s parent (who must be at least age 24) to buy the bonds. If the bonds are later cashed and the money used to pay qualified higher education costs for the grandchild, the interest will escape taxation. The exclusion is phased out for higher-income taxpayers. Series I bonds have the additional feature of being indexed to inflation. Maximum annual purchases of Series I or Series EE are $30,000.

If I set up a 2503(b) trust to pay for my children’s education, is it exempt from gift taxes?
A useful way of funding college costs is to set up a 2503(b) trust, named after the Internal Revenue Code section that created them. Such a trust works especially well when large sums are involved. Parents can contribute up to $20,000 per year per child to this kind of trust and still qualify for the annual gift tax exclusion. Funds within the trust can be accumulated and principal payments delayed until college. A 2503(b) trust requires that all income be paid annually or more frequently to the beneficiaries, but principal payments can be delayed until 21 years of age. Income distributions can be planned by various investment strategies, and principal can often be left in trust for periods of time exceeding the child’s 21st birthday.

Can I set up a mutual fund account to help my grandchildren start saving for college?
If you are a grandparent who’d like to help your grandkids start saving for college but don’t like the idea of setting up a trust, consider starting a mutual fund account for each of the children you want to help. You can establish a mutual fund account for each grandchild, using the grandchild’s Social Security number with a parent designated as guardian. The address of the grandparent can be listed on the account to facilitate ongoing deposits. It is important to make sure that tax information is forwarded to the parent each year.

Are money market funds a good investment for college?
Money market funds are usually a lousy way to save for future educational costs. That’s because money market funds, like savings accounts, don’t yield enough interest after taxes to keep you ahead of the rate of inflation in the cost of college. Educational costs are expected to keep rising faster than the overall inflation rate, so you need to make investments now that have the potential to provide much greater returns than money market funds will generate.

Are zero-coupon bonds a good way to finance my child’s college education?
Zero-coupon bonds can be a good investment if you know that you will need a lump sum on a specified date in the future, such as when your child is ready to enter college. "Zeros" are sold at a deep discount to their face value generate no ongoing interest payments, and have no reinvestment risk. Instead, you get to redeem the bond for its full face value when it matures. The difference between the discounted price you paid and the bond’s face value when it matures represents your return. Because of the way they work, zeros can be an excellent way to finance a child’s future educational expenses. For example, assume you purchase a zero with a $10,000 par value for your child’s college education in 10 years. If the zero has an implied yield of 6%, you would pay $5,537 today and receive $10,000 when he or she enters college. The higher the implied yield, the greater the discount and lower initial price you must pay. You can buy even more zeros if you expect college to cost more, or buy different zeros that mature at different dates (a strategy known as laddering bonds) to fund the child’s sophomore, junior and senior years as well. One drawback to zeros is that you have to pay tax on the "implied interest" each year even though you don’t collect anything until the bond matures. Check into tax-advantage education IRAs to shelter such income from taxes.

Is it a good idea to use Series I (inflation-indexed) Savings Bonds to save for college?
Series I Savings Bonds are attractive in saving for college expenses. Series I Savings Bonds are U.S. Treasury bonds, inflation-indexed, and have the same tax-exempt benefits as Series EE Savings Bonds. In addition, you can purchase up to $30,000 a year of Series I Savings Bonds. Series I Savings Bonds can also be purchased through the, eliminating broker fees, and in a variety of denominations.

Are Series EE savings bonds a good way to save for college?
Savings bonds are issued by the U.S. government, so they are extremely safe and an easy way to put aside money. They’re also inexpensive. A $50 savings bond, which you can redeem at its full face value when the bond matures, can be purchased for only $25. The most popular type of savings bond is the Series EE bond, which many parents purchase to help fund a child’s college education. Series EE savings bonds can be good choices because of their low risk and tax advantages when compared with CDs and because the federal tax is deferred until the bonds are redeemed. The interest is also exempt from state tax. For clients with joint modified adjusted income below $68,250 (indexed for inflation), the interest is free of federal income tax if the proceeds are used for qualifying educational expenses. Still, not all college-related costs are considered "qualifying educational expenses" for tax purposes. Tuition and fees to attend a college, university, technical institute or vocational school qualify for the special tax break. Expenses for a student’s room and board do not. Series EE Savings Bonds can also be purchased through the, eliminating broker fees, and in a variety of denominations.

What are the pros and cons of Series EE savings bonds?
Like other Treasury securities, Series EE savings bonds have the backing of the full faith and credit of the U.S. government, and the interest they pay is free from state and local (but not federal) income taxes. U.S. savings bonds are available in much smaller denominations than other Treasuries. You can buy them for as little as $25 apiece. They are issued at half their face value. When you buy a $100 bond, for instance, you pay $50 for it. They have no set maturity date and pay no current interest, but you can redeem them at any time from within six months of buying them to as long as 30 years later. You owe federal tax on the interest earned only when you redeem the bonds, unless you use them to pay tuition for college education. What are the disadvantages? In return for the safety, liquidity and tax advantages, you receive a lower yield than is available from most other bonds. How much lower depends on market conditions. Also, instead of paying your taxes along the way, you will have to pay the entire tax bill when you redeem the bonds. Series EE Savings Bonds can also be purchased through the, eliminating broker fees, and in a variety of denominations.

Is it true that there is a limit on the amount of Series EE savings bonds I can purchase?
There’s no limit on the amount of U.S. Government Series EE savings bonds you can buy over your lifetime, but by law, you can only buy up to $30,000 worth annually, and that’s based on the face value. So if you paid $15,000 today for bonds that can be redeemed for $30,000 when they mature several years from now, you will have to wait until next year before you can buy more.

Can I redeem Series EE savings bonds before their stated maturity date?
You can redeem Series EE bonds before they mature, but the government obviously won’t be willing to pay their full face value. Under no circumstances can the bonds be redeemed within six months of the date that you actually bought them.

If I buy Series EE savings bonds, when will my interest be credited?
Interest on a Series EE savings bonds is credited on the first day of every month, regardless of how many days you hold the bond. As a result, you can boost the return from an EE investment by "timing" your sale if you don’t want to hold the bonds until maturity. For example, say it’s the last day of the month and you want to sell your bonds. By waiting just one more day -- when the new month begins -- you’ll collect an additional 30 days worth of interest.

What are Series H and Series HH savings bonds?
Series H bonds were government savings bonds that have been replaced by Series HH bonds. The government quit selling Series H bonds in December 1979. Series HH bonds pay interest semiannually, providing current income. The interest paid is a fixed rate, which can change 10 years after issue. Series HH bonds cannot be purchased for cash and are acquired only through the exchange of Series E/EE savings bonds. Exchanging the Series E/EE bonds for Series HH bonds lets you continue to defer Federal taxes on the accumulated interest you earned on your previously-held Series E/EE savings bonds. Visit the for more information and forms ordering.

What are the tax implications of reissuing savings bonds and transferring them to my son’s name?
Tax-wise, you can make a mistake by having bonds reissued and placed in someone else’s name. When an original bond-owner has the bonds reissued in someone else’s name, the Internal Revenue Service considers the name-change a "disposition." The IRS essentially treats a disposition as a sale, which means you will have to report all the interest the bonds have earned over the years on your tax return even though you haven’t really sold them. Your son, meanwhile, will be responsible for paying taxes on the interest income the bonds generate in the future. If it’s any solace, at least he’ll be able to defer those taxes until he actually sells the securities -- or makes the same mistake you did by having them reissued in another person’s name.

Why does saving in my child’s name hurt my ability to qualify for financial aid?
Many parents who want to start saving for a child’s college education are tempted to put the investment account in the child’s name rather than their own. By doing so, the folks think they will bolster the chances that their child will eventually qualify for college financial aid. In reality, though, saving in your child’s name or transferring your assets over to him (or her) will likely hurt your chances of getting financial help. That’s because the people who run the various financial aid programs know that most parents have a lot more expenses than their kids do. So, when they look at an aid application, they usually expect the parents to use only about 5.6% of their money to pay for tuition and related costs. The child, on the other hand, is usually expected to give up about 35% of his or her money to meet college costs. As a result, it’s usually better to save the money in your name, not your child’s.