Sending the Grandkids to College, Commutatively

‘I bet on this horse at twenty-to-one. It came in at half-past-four.’ – long-dead British comedian Tommy Cooper

George Weber: ‘I am a recently retired aerospace engineer and look forward to supporting my grandchildren when they approach college age –several years away. Should I establish Qualified State Tuition Plan accounts on their behalf, using funds from my IRA? My reading of the QSTP vehicle is that the answer is, no, I should simply retain the funds where they are, manage them prudently, and write checks directly to the college(s) of choice, when the time comes — paying the tax at that time. Yes?’

☞ Yes. The funds are already growing tax-deferred for you. You may as well keep Uncle Sam’s portion of your money working for you as long as you can.

Let’s assume you have $100,000 in your IRA and that your combined federal and state tax rate is 40%. If it continues to grow at 9% per year for another 10 years before being drawn out for college, it will grow to $236,736, less 40% tax, netting $142,042 for the grandkids.

But if the money were drawn out now, triggering a$40,000 tax bill (plus penalties if you were not yet 59-1/2), there’d be$60,000 left to reinvest in a QSTP. The plans vary from state to state – see savingforcollege.comfor details – but basically, that $60,000 would grow tax-deferred and then,when you withdrew it for your grandkids education, the appreciation of that$60,000 would be taxed at their (presumably low) rate.

But if you did this at all, why not just roll over the money into a Roth IRA instead of a QSTP? That way, the appreciation of your $60,000 would never be taxed (and so you’d have more flexibility using the money for something else if you wanted). Assuming your tax bracket remains the same,you’d come out about even: $100,000 growing for 10 years at 9% and then taxed at 40% comes to the same thing as $60,000 growing for 10 years at 9% and nottaxed at the end. (This is either an astounding coincidence, or else rooted in an elemental arithmetic principle we learned in the seventh grade: multiplication is commutative.)

The logic for leaving your IRA alone is even stronger if you assume that, in a combined 40% bracket now (say), you may be in a lowertax bracket by the time you begin withdrawing funds. (Then again, if Congress does cut rates sharply, you might then consider cashing in that IRA, paying the tax, and rolling it into a Roth IRA,before the rates went back up.)

The one exception to all this are the ‘pre-paid tuition plans’ some states offer. If you’d like the peace of mind of knowing that, however college tuition may inflate in your state, and however badly the stock market may fare, your kid is paid up,no matter what, you might want to go with such a plan. Most allow at least some flexibility if your grandchild should choose to go to a college out of state. The math might favor your forgoing that peace of mind; but peace of mind has a value of its own.

Steffan H. Hagendorf: ‘Contrary to what Less said Tuesday, you can establish a 529 Qualified State Tuition Plan with funds from an UTMA (Uniform Transfers to Minors Act) Account. Holdings within an UTMA can be liquidated and that cash can in fact be used to fund a 529 plan. The 529 plan will receive an UTMA designation ensuring that the beneficiary can not be changed.’

The estimable Less Antman replies: ‘I KNEW ONE OF YOUR READERS WOULD SAY THIS! I KNEW IT, I KNEW IT, I KNEW IT! While it is technically true that you can establish a 529 with UTMA funds, it willthen still be an UTMA, which means the child still becomes the account owner at 18 or 21. Since the purpose of someone trying to convert the UTMA to a 529 is to retain control of the account for a longer time, it fails in the most substantive way. Furthermore, since the 529 can’t be rolled to another child in that case, it fails that benefit as well. There is immediate taxation on the liquidated UTMA funds, and the new earnings will then all be taxed at 15% on withdrawal with no capital gains rate possibilities. In other words, it may be technically a possibility, but the type of 529 created is NOT the type of 529 that anyone should seriously contemplate. That, at least, was the consensus view of the other advisors I consulted. (There is virtually no case law on 529 plans given their recent invention.)

‘People putting money into UTMA accounts and then regretting it have long been looking for ways around the loss of control problem for decades, but the fact is that an UTMA is a trust account, and the provisions turning control over to the child are irrevocable. A 529 rollover won’t prevent that, so such a rollover is only a way to increase taxes and reduce investment options with no benefits.

‘That said, I agree with Steffan when he says [not quoted above] that funding an UTMA/529 combination, when you set things up for your kids,is often the best choice. That is actually what I recommended in Tuesday’s column: using the 529 for direct college costs and establishing a small UTMA for spending money and the lesson in dollar-cost averaging. But that is different from the issue of rolling UTMA funds into a 529 Qualified State Tuition Plan.’