Opening a savings account in a child's name may seem like a great way to give Junior a head start on a lifetime of thrift. However, it can come back to haunt families, especially when college years roll around.
In fact, choosing the wrong savings vehicle for your children's future cash could cost them thousands in avoidable taxes and missed financial aid.
"In the federal formula that determines how much financial aid a student receives, there are asset protections for money in a parent's name that are not there for money in a student's name," says Robert Helgeson, director of financial aid for Valparaiso University in Indiana.
"If a parent has $100,000 in assets, the government is going to expect them to contribute $6,000 of it to education. If a student has $100,000 in assets, the government will expect $20,000."
Students can have up to $3,000 stashed away in a checking or savings account in their name without losing any financial aid, according to the U.S. Department of Education.
However, for every dollar above that threshold, 20 cents is subtracted -- first from federally funded scholarships and grants the student would have been eligible for, then from federally funded loans.
Because financial aid is determined based on income and assets from the year prior to applying for aid -- in most cases, the student's junior year in high school -- students with large amounts of savings in their name could end up losing a hefty sum of free college cash.
Fortunately, there are several ways for parents to save that will not put their child's future financial aid at risk. The following are three places to safely stash the cash:
529 college plans
One popular method is to save for college through a college savings plan.
Operating similar to IRA and 401(k) plans, 529 college savings plans allow parents to save for a child's education tax-free through an array of investment options. Some age-based investment packages place funds in aggressive investments when the child is young, then automatically switch funds to more stable options as the child approaches college age.
These plans offer major tax advantages, says Craig Parkin, director of institutional client services for TIAA-CREF Tuition Financing, the investment organization that administers Kentucky's state-sponsored college savings plans.
"The gains on the accounts are tax-deferred, and once the funds are used to pay for qualified tuition expenses, parents will never pay taxes on those funds," he says.
Money in these accounts can be used for undergraduate or graduate studies at any accredited two- or four-year campus in the United States. Savings in a 529 plan belong to the parent, not the child.
"A 529 college savings plan is considered a parent's asset because the parent is the account owner and they can change who the beneficiary is," Parkin says.
Kelly Campbell, a Certified Financial Planner and founder of Campbell Wealth Management in Fairfax, Va., cites another advantage of these plans.
"An additional benefit with a 529 plan is that if the child says they don't want to go to college, the parents or whoever owns the account can change the beneficiary," Campbell says. "That way, you know the money will be used for education. They can't just take it and run."
While 529 savings plans offer big advantages, they also come with a few restrictions. According to the U.S. Securities and Exchange Commission Web site, 529 college savings funds can only be pulled out tax-free for qualified education expenses, including tuition, books, fees, supplies, and room and board. Money spent on unqualified expenses is subject to income tax and a 10 percent penalty on earnings.
There are also restrictions on how money in these plans can be invested.
"With 529 plans, (plan holders) don't have a lot of control over their investment options and can only change their plan once a year," says Matthew Havens, a Certified Financial Planner and partner at Global Vision Advisors in Hingham, Mass. "If your investment philosophy doesn't fit into the options they offer, a 529 plan can feel like handcuffs."