Until recently, astute high-net-worth parents wishing to fund their children's future education expenses could save a bundle in taxes by transferring money or investments to accounts established under the Uniform Transfer to Minors Act or Uniform Gifts to Minors Act (UTMA/UGMA).

This strategy reduced taxes in two ways: First, the initial batch of each year's realized gains and income in the accounts were taxed at the kids' low rate — if they were taxed at all. Secondly, when the accounts were liquidated (usually to pay for college costs), children 18 and over would likely only be subject to the long-term capital gains tax rates of filers in the lowest bracket.

But thanks to kiddie tax legislation that is about to take effect, the aforementioned tax advantage is about to be severely reduced, while the drawbacks of the strategy will remain in full force. Here's what's happening to the taxation of UTMA/UGMA accounts, and some solutions you can use to guide puzzled parents out of the mess.

The (Pretty) Good Old Days

The nice thing about UTMA/UGMA accounts is they allow parents to deposit and manage money for their minor children without the hassle and fees of establishing and administering a formal trust.

The only downsides are that the accounts receive unfavorable financial aid status once the children apply for college, and that the kids can take control of the money upon reaching adulthood (18 to 21, depending on the state) and do with it what they wish.

But the wealthier parents are, the more likely it is that the plusses outweigh these minuses. First, almost any stock, bond or mutual fund can be used within an UTMA/UGMA. Also, there are no restrictions on how money taken out of the account can be used — as long as it is for the benefit of the child, above and beyond what would be considered to be the normal financial obligations of the parent.

The biggest advantage, though, is the favorable tax treatment received on investment income and gains in UTMA/UGMA accounts for kids under a certain age: a substantial amount is either tax free or taxed at the child's (much lower) tax rate. For example, this year $850 is tax-free and another $850 is taxed at the kid's rate, for any accounts held for a child under 18. Only gains and income over $1,700 are taxed at the parents' likely higher rate.

Also, once the kid reaches the age of 18, all realized investment returns are taxed at his tax rate. Families who had established UTMA/UGMA accounts for children who turn 18 by next year were eagerly anticipating 2008. That's when the capital gains tax rate for filers in the lowest income tax bracket will be at most 5 percent, and as little as 0 percent.

In sum, under today's laws, kids in (or about to enter) college can sell highly-appreciated investments held in UTMA/UGMA accounts to pay for tuition and expenses, yet owe little or nothing in capital gains taxes.

The New Tax Game

That's all about to change. Starting in 2008, the taxation of UTMA/UGMA accounts for most families is going to get much more complex and probably, more expensive. Under new legislation, capital gains taxes for individuals in the lowest brackets will still fall to between 0 and 5 percent in 2008 — except for those under 19 years old, or for those who are aged 19 to 23, are full-time students and can be considered dependents of their parents.

According to Joe Hurley at www.savingforcollege.com, kids falling into the above categories will have “kiddie tax” rates extended to realized gains and income, whether the assets are owned in custodial accounts, or outright by the children themselves. The calculations are complex, but in the end, this means more tax dollars to be paid out.

But there are some ways you can help parents out of this predicament while minimizing both hassle and future taxes:

  1. Consider realizing gains before the end of 2007 for college-bound dependent children under the age of 23. Yes, there may be a small capital gains tax to pay by next April 15. But left until next year and beyond, gains taken in UTMA/UGMA accounts may be taxed at the parents' likely higher rate of up to 15 percent.

    For those families who might qualify for financial aid, though, be careful: a sale at the wrong time might artificially raise the child's income, and lower his or her chance of getting need-based assistance. You can find out more at www.finaid.org or www.fafsa.ed.gov.

  2. Spend down assets currently in UTMA/UGMA accounts on non-college costs. Keep in mind that allowing parents to withdraw money from the accounts to pay for the kids' Cheetos and instant messaging bills probably won't pass a smell test administered by the IRS.

    But big, discretionary expenses like summer camp fees or a new car for the kid are more likely to be accepted. Tapping UTMA/UGMAs for needs like these allows parents to redirect the money that would have otherwise come out of their own pocket, and deposit it into vehicles that could mean less income taxes and more financial aid.

  3. Re-focus on 529s for both assets currently held in the names of your clients' children, as well as new deposits meant to pay for future education expenses. Since there is no tax reporting required while money remains in 529s, the move may save your clients almost as much in headaches as it does in taxes. And when it's time to tap 529s to pay for college costs, the tax bill on any gains is likely to be zero — as long as the withdrawals are used for qualified higher education expenses.

Some parents are hesitant to move money to 529s because of a small chance that they may wish to use the money for purposes other than education. You can remind them that in that event, taxes and penalties on non-qualified withdrawals only apply to the earnings portion of what is withdrawn, not the part that represents the original deposit.

Congress is expected to use these more restrictive rules to raise $1.4 billion in additional taxes from targeted families over the next ten years or so. Based on the expected cost and complexity, parents may want see if the law can be left alone, and offer to hold one big nationwide bake sale instead.

Writer's BIO: Kevin McKinley CFP(R) is a Vice President-Private Wealth Management at Robert W. Baird & Co., and the author of the book Make Your Kid a Millionaire (Simon & Schuster). You can reach him at kmckinley@rwbaird.com