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A family can lose money with Tax-Favored college savings plans

By: Susan M. Dynarski

College savings plans, such as Coverdell Education Savings Accounts (ESAs), 529 plans, and Uniform Transfers to Minors Act (UTMA) accounts, all offer tax-favored treatment for college savings. But a study released in 2004 shows that they actually can do more harm than good.

Trap: The savings increases a family's wealth, which in turn can reduce a student's eligibility for financial aid. This reduction, combined with the effects of the Tax Code, can cost more than 100% of the amount accumulated in the tax-favored investment account - meaning that the family loses from saving.

This is a particular risk for middle-income families who are on the margin for aid, which often include families with incomes of as much as $100,000 per year.

Analysis shows that such families with savings in an UTMA account will lose more than 100% of savings because these assets are heavily assessed by financial aid formulas as the student's own wealth that is available to pay tuition.

Savings in an UTMA account can cost as much as $1.24 for every $1 saved. Savings in 529 plans and ESAs receive a lighter assessment as parental property but still reduce available financial aid for such families, and so may return less than expected.

Better: Such families may receive the best returns on saving through an IRA or other retirement plan that is tax-favored and not assessed at all under financial aid formulas, preserving maximum tuition assistance.

Grandparents should beware of placing investment assets in a child's name for similar reasons. They may do much better by keeping assets in their own name to preserve eligibility for tuition aid, and later making a gift to the child's family as needed.

Important: Every family's situation is different. Be sure to discuss college saving strategies with a college tuition aid expert to see how - and if - they will pay off after counting their effects on eligibility for tuition aid.