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Recent tax laws affect many college savings strategies

William Creekbaum

Recent changes in tax legislation have thrown a wrench into the college savings plans of many parents. They are finding that their children with unearned income are suddenly being hit up for higher taxes. The Small Business and Work Opportunity Tax Act of 2007 (“2007 Small Business Tax Act”) that was passed on May 25 has extended the kiddie tax to those who are 18 years old or who are full-time students under age 24. The expanded kiddie tax rules apply only to dependent children who have income on investments and whose earned income does not exceed one-half the amount of their support. This provision is effective for most families as of Jan. 1, 2008.

Congress has changed the rules on the kiddie tax twice in the past two years. First there was TIPRA (The Tax Increase Prevention and Reconciliation Act of 2005) that made the kiddie tax applicable to children under the age of 18 (up from 14). Now the 2007 Small Business Act ensnares a good number of parents with college-age dependents who had planned on using appreciated stocks or the earnings from custodial accounts to pay for higher education expenses. The new legislation is meant to prevent parents from shifting unearned income to children who are in lower tax brackets.

As a reminder, the kiddie tax, even in its expanded version, exempts the first $850 of unearned income, and the next $850 of unearned income is taxed at the child’s rate. Any financial plan that included UGMA/UTMA custodial accounts as part of a family’s education funding strategy will not reap the expected benefit of lower tax rates assessed on assets gifted to minors. Annual income over $1,700 that is generated in these accounts will now be taxed at the parent’s highest marginal tax bracket. Furthermore, the 0 percent capital gains tax rate for low-bracket individuals that would have been a boon for custodial account owners in 2008, 2009 and 2010 has been eliminated.

The upshot: This tax change makes custodial accounts a less attractive way to save for college education and other long-term expenses. If you have custodial accounts set up for minors or are thinking of gifting appreciated securities to these accounts, be sure to talk with your tax advisors before year end to determine if you can take advantage of any potential tax benefits for 2007.

Your financial advisor can help identify alternative tax-advantaged ways to save for a child’s college education and help you make sense of your entire financial picture.

Here are some college savings strategies you may want to consider:

Recent legislation also boosts 529 College Savings Accounts as the preferred choice for college savings. Funds within a state-sponsored 529 plan grow tax-free, and if used for qualified college expenses, the funds come out of the account tax-free as well. Many states also offer state tax deductions for contributions to a 529 plan. Families with UGMA or UTMA accounts may want to explore the potential benefits and tax implications of transferring these assets to a 529 plan. Your financial advisor can provide you with information about the specific risks of investing in 529 plans, including the potential for investment loss.

Another tax-free savings option for funding qualified college expenses is the Coverdell Education Savings Account. However, the annual contribution limit on a Coverdell is just $2,000 and the amount you can contribute starts to drop at $95,000 (in adjusted gross income) for single filers or $190,000 for married filers.

For information, e-mail me at William.a.creekbaum@smithbarney.com or call 689-8704. Smith Barney does not provide tax and or legal advice. Consult your tax and or legal advisers for such advice.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada.