As a parent, you may be concerned with setting up a financial plan to fund future college costs for your children. If your children are already of college age, your goal may be to pay for current college costs or those that are right around the corner. There are several approaches that can be pursued to take maximum advantage of tax benefits while also saving for these future college expenses.

Transferring ownership of assets to your children is one way to help finance college costs. A taxpayer and spouse can each transfer up to $26,000 in 2011 in cash or assets to each child with no gift tax consequences. And for 2011, if the child isn't subject to the "kiddie tax," he or she is taxed on income from assets entirely at his or her lower tax rates—as low as 10% (or 0% for long-term capital gain). However, where the kiddie tax applies, the child's investment (i.e., unearned) income above $1,900 for 2011 is taxed at the parents tax rates and not the child's tax rates. The kiddie tax applies if the child hasn't reached age 18 before the close of the tax year or the child's earned income doesn't exceed one-half of his or her support and the child is age 18 (or is a full-time student age 19–23). A variety of trusts or custodial arrangements can be used to place assets in the children's names. Note that it's not enough just to transfer the income to the children, that income would still be taxed to the parents. The parents must transfer the asset that generates the income to their names.

Series EE U.S. savings bonds offer two tax-savings opportunities when used to finance the child's college expenses. One advantage is the parent doesn't have to report the interest on the bonds for federal tax purposes until the bonds are actually cashed in. Also, the interest on "qualified" Series EE and Series I bonds may be exempt from federal tax if the bond proceeds are used for qualified college expenses. To qualify for the tax exemption for college use, the parent must purchase the bonds in their own name or jointly with their spouse, and not in the child's name. The proceeds must be used for tuition, fees, etc. and not for room and board. If only part of the proceeds are used for qualified expenses, then only that part of the interest is exempt. If the taxpayers adjusted gross income (AGI) exceeds certain amounts, the exemption can be phased out. For bonds cashed in during 2011, the exemption begins to phase out when AGI hits $106,650 for joint return filers ($71,100 for single filers) and is completely phased out if AGI is at $136,650 for joint filers and $86,100 for singles.

A qualified tuition program (also known as a 529 plan) allows for the purchase of tuition credits for a child and also allows for contributions to an account that is set up to meet a child's future higher education expenses. Qualified tuition programs can be established by state governments or by private education institutions. Contributions to these programs are not tax deductible for federal tax purposes, but may be for state income tax purposes. The contributions can be treated as taxable gifts to the child, but they may be eligible for the annual gift tax exclusion ($13,000 for 2011). A donor who contributes more than the annual exclusion limit in a given year can elect to treat the gifts as if they were spread out over a 5-year period. The earnings on the contributions accumulate tax-free until the college costs are paid from the funds. Distributions from qualified tuition programs are tax-free to the extent the funds are used to pay qualified higher education expenses. Distributions of earnings that aren't used for qualified higher education expenses will be subject to income tax plus a 10% penalty tax.

A Coverdell ESA (Education Savings Account) can be established and parents can make contributions of up to $2,000 for each child under age 18. The right to make these contributions begins to phase out once AGI is over $190,000 on a joint return ($95,000 for singles). If the income limitation is a problem, the child can make a contribution to his or her own account. Although the contributions aren't tax deductible, funds in the account aren't taxed and distributions are tax-free if spent on qualified education expenses. If the child doesn't attend college, the money must be withdrawn when the child turns 30 and any earnings will be subject to tax and penalty, but unused funds can be transferred tax-free to a Coverdell ESA of another member of the child's family who hasn't reached age 30.

The above are just some of the tax-favored ways to build up a college fund for your children. If you wish to discuss any of them, or other alternatives, please contact your Dermody, Burke & Brown tax advisor.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.