College tuition increases at about 2-3 times the rate of inflation. By the time today’s newborns are 18, experts predict the total cost to send them off to a “safe space” for four years will be nearly $500,000. With such sobering stats, it’s no wonder parents worry about paying for Junior’s education even before he makes his grand exit from the womb.
If you’re a parent or plan to be one soon, it’s never too early to plan for college. As you’re doing this planning, at some point a well-meaning friend or relative, or perhaps a “financial planner” (aka salesperson) with ulterior motives, will advise you to start a college fund in your child’s name. This is known as a custodial account. The money in a custodial account is taxed at your child’s tax rate, not yours, and since most kids make little to no money, the tax savings can be enticing.
Putting a college fund in your kid’s name is a terrible idea, because it drastically reduces the amount of financial aid for which your kid is eligible. Unless you’re very wealthy (meaning you’re in one of the top three tax brackets), maximizing financial aid will save more money in the long run versus lowering the tax rate on your child’s college fund. If you’re in one of the highest brackets, saving in your child’s name might make sense for the tax savings, especially if you’re planning to pay for college out of pocket — in which case financial aid implications don’t affect you.
When your child applies for financial aid, the first thing the school does is analyze your family’s income and assets. Your financial picture determines how much the school expects you to pay toward tuition and fees. This is known as your expected family contribution (EFC). The difference between your EFC and the cost of college is covered by student loans (usually with low interest that is often subsidized by the government until your child graduates), and scholarships and grants (which do not have to be paid back at all).
If you aren’t paying for college out of pocket, you want the lowest EFC possible so your kid gets the most financial aid possible. Even if it’s mostly loans, take advantage of them. As of this writing, the federal student loan interst rate for undergraduates is only 4.29% — and the government usually subsidizes (pays on your behalf) the interest until your child graduates. This is a fantastic deal. Right now a student loan (which is unsecured debt) is nearly as cheap as a mortgage (which is secured by your most valuable asset, your home).
Borrowing money for college at a low interest rate lets you keep more of your money invested at a higher interest rate. This is called leverage. It’s how banks make money, borrowing at low interest and investing/lending at higher interest. Growth stock mutual funds return 10% per year on average. If stocks scare you because of the risk, there are conservative, safe investments (such as investment-grade corporate bonds) that can get you more than 4.29%.
And depending on where your kid goes to school and what kind of student he is, you might not have to borrow a dime above your EFC. Some schools, such as Vanderbilt, have eschewed student loans and cover a student’s costs beyond his EFC with 100% grants. Other schools will convert some or all of a student’s loans to grants if he maintains above a certain GPA. Even if your child’s school doesn’t offer these perks (or if he parties more than studies and doesn’t qualify), he can have his loans forgiven by pursuing certain jobs, such as social work or teaching at a high-risk public school.
In summary, unless you’re paying for college 100% out of pocket, a lower EFC is a better EFC!
So why does it matter whose name your kid’s college fund is in?
Because when calculating EFC, not all money is treated the same. The vast majority of money held in your name is assumed to be earmarked for purposes other than paying for college. The school expects you to contribute a very small amount — as little as 5-6% — of this money toward college. Money held in your child’s name, by contrast, is assumed to be for college. (What else would a minor child spend $100,000 on, unless she’s one of those Porsche-driving brats on My Super Sweet Sixteen?) The school counts 20% or more of the money held in your child’s name toward your EFC.
A family with a college fund in their child’s name will have a much higher EFC than an equivalent family with a college fund not in their child’s name. The first family may save a little in taxes along the way, but their kid will be eligible for much less free and low-interest money. The second family comes out ahead in the end because the amount they gain in financial aid far outpaces the extra taxes they paid along the way.
For example, if both families save $200,000, the second family only has to spend $10,000-12,000 of it on college and can potentially receive free money to cover the rest, or at worst money at a very low interest rate. The first family has to put $40,000 of their savings toward college. If the second family keeps that $30,000 difference in good mutual funds, based on historical averages they should earn another $50,000 in interest income within 10 years. Their student loan interest on $30,000 over 10 years, by contrast, is about $16,000. Net profit: $34,000. Leverage, baby.
(Also, I don’t want to get too technical and do a bunch of tax calculations here, but rest assured that no scenario exists in which the first family saves anywhere near $34,000 in taxes by putting the money in their child’s name.)
TL/DR summary: If you’re part of the 99% and expect to rely on financial aid in any way for your child’s education, do not start a college fund in your kid’s name. If you’re part of the 1% and are able and willing to pay for your child’s education out of pocket, go ahead and start a college fund in your child’s name and enjoy the tax savings.