Kevin: ‘I have a niece and a nephew (12 and 10). I’d like to help pay for their college education. The deal: They go to college by the time they’re 20 and I’ll kick in a few thousand a year. They skip college and the money is mine. (In other words, they can’t blow it on a fancy car, etc. It’s earmarked specifically for school.) Any suggestions as where to put the money I’ve been saving for them? I’m thinking I-bonds? I’d like to take advantage of any tax breaks, of course. Not being their parent, I’m not sure what’s the best course to follow. Any advice is MUCH appreciated.’
☞ The estimable Less Antman (as in ‘Ask Less,’ at upper left) replies:
Kevin, Andy asked me to tackle this question, and threatened to write about politics for 50 consecutive days if I refused. While you could put the money into a college 529 plan, retaining control and the ability to keep the funds . . . should you withdraw the money for yourself, you would be subject to ordinary income taxes and at least a 10% penalty. This would work out well if they DID go to college (zero taxation of income), but terribly if they didn’t.
Since you are only talking about a few thousand a year, the most logical thing to do is simply place the money into stock index funds that remain in your name, bearing miniscule amounts of taxation on the dividends at the current low rates. If they matriculate, you would then gift the shares into custodial accounts for each of them (any one person can currently gift up to $11,000 per calendar year to any other person without having to file a gift tax return), sell the shares under their names in the custodial accounts, and they would only owe taxes at a 10%, 5%, or even 0% rate, depending on the exact year and the subsequent changes in federal tax law. You could then write checks for tuition, room and board, or just hand them the money.
If you were absolutely, positively sure you were going to spend this money on qualified college costs (for them or others relatives), you’d use the 529 plan, which should result in zero taxation upon redemption for college. But since you want to have it both ways, you need to accept the compromise and the small taxation that will result at their long-term capital gains rates in the year or years of sale.
I-Bonds are a bad idea: the tax-free treatment of them once redeemed only applies to college costs for yourself or a dependent, and these are not your own children, so I presume they are not dependents of yours. You cannot make a gift of I-bonds that are originally in your name to take advantage of their lower tax brackets (you can, of course, buy I-bonds as a gift, but they will be in the name of the kids from the beginning and won’t be reclaimable by you). Furthermore, the eventual taxation of I-bonds will be at ordinary income tax rates. They might be less volatile, but their returns would normally be expected to be far less than that of equities over the time period involved, and even if you don’t believe that, it would be better to buy your interest-bearing investments in tax-sheltered retirement accounts while investing in equities in your taxable accounts (including the ones that are being used to save for the nieces/nephews).
You are stuck with SOME taxation if you cannot guarantee the money will be spent on college, but the use of index funds and transfers later will get pretty close. If you have other index funds, you could simply include the sums being set aside for them in the same account. If you prefer separate accounts, TIAA-CREF has an equity index fund which can be started with commitments as small as $50 per month in contributions, and they have an international equity fund which, while not purely an index fund, is indexed for half the portfolio and, therefore, has relatively small turnover and dividend distributions, virtually all of which should qualify for the special dividend rate that has resulted from the recent tax act.
Thank you, estimable Less!