Apr 26, 2018
College seems a long way off when you bring your new baby home from the hospital, but the far-off nature of higher education shouldn’t move college savings strategies too far down your list of priorities. The good news is that there are several methods that can help you get started saving now, potentially saving your child (and you) from student loan debt down the road. More good news: We want to help you choose the right approach for your family! On this Worth It episode, Dustin R. Granger, CFP® and I explain the basics of 529 Accounts, Coverdell Education Savings Accounts, and Custodial Accounts.
Section 529 plans, named for the section of the tax code that provides for their favorable tax treatment, are formally called “qualified tuition programs.” These investment programs are designed to help pay for future qualified education expenses. An advantage of this type of account is that it’s tax-free. Established for college costs and recently expanded to include $10,000 annually for K-12, 529s grow tax-deferred AND receive tax-free treatment on withdrawal if you use them for qualified education expenses. Currently, an individual can contribute up to $15,000 in one year for each beneficiary without incurring gift taxes, or a lump sum up to $70,000 as long as no further gifts to or for that individual are made during the next five years. One disadvantage to be aware of, if your child doesn’t attend college and wants to use the money for something else. At that point, the funds are subject to taxes on growth and a 10% penalty. Although not ideal, at least the account is able to grow tax-deferred for many years. Keep in mind that one way out of this problem is to change the beneficiary of the 529 Plan. So if one child does not use the funds, perhaps another child or relative can.
Formerly known as an Education IRA, a Coverdell Education Savings Account (ESA), is a federally sponsored, tax-advantaged account set up to pay for qualified education expenses. Coverdell ESAs can be opened for any student who is under the age of 18 years. Coverdell ESA contributions are not tax-deductible, but, like a Roth IRA, amounts deposited in the accounts grow tax-free until withdrawn. The annual contribution limit is a maximum of $2,000 per beneficiary. Contributions can be made by individuals with modified adjusted gross income of less than $90,000. For a couple filing a joint return, that amount is $220,000. Coverdell ESA withdrawals can be used to pay for qualified education expenses at elementary and secondary schools (K-12), including public, private, or religious schools, as well as any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. This includes virtually all accredited, public, nonprofit, and private postsecondary institutions.
UGMA and UTMA accounts are considered the granddaddy of college savings accounts. The UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) are nothing more than custodial accounts, which are used to hold and protect assets for minors until they reach the age of majority in their state. The account format requires a custodian to hand over control of the assets to the child at anywhere from age 18 to 21, depending on the state. A custodian can initiate a withdrawal for the benefit of the child as long as the expenses are for legitimate needs. Any expense that is for the benefit of the child, such as pre-college educational expenses, may be paid from the custodial account, at the custodian’s discretion. Unlike other college savings accounts, however, these expenses are not limited to education and can be used for anything related to the child. Likewise, upon becoming a legal adult, the child can use the money without limitations. Unlike 529 plans and Coverdell ESA’s, there’s no ability to transfer the account to another child or change beneficiaries.
529 Accounts:
Pros - This type of account is it’s tax-free. 529s grow tax-deferred AND receive tax-free treatment on withdrawal if you use them for qualified education expenses.
Cons - If your child doesn’t attend college and wants to use the money for something else. At that point, the funds are subject to taxes on growth and a 10% penalty.
Coverdell Education Savings Account:
Pros - Coverdell ESA contributions are not tax-deductible, but, like a Roth IRA, amounts deposited in the accounts grow tax-free until withdrawn.
Cons - The earnings portion of a Coverdell ESA distribution that is not considered to be for qualified education expenses will be included in the gross income of the beneficiary and an additional 10 percent tax penalty may apply. Another possible disadvantage is the annual contribution limit is maxed out at $2,000 per beneficiary.
Custodial Accounts
Pros - Any expense that is for the benefit of the child, such as pre-college educational expenses, may be paid from the custodial account, at the custodian’s discretion.
Cons - Upon becoming a legal adult, the child can use the money without limitations. Unlike 529 plans and Coverdell ESA’s, there’s no ability to transfer the account to another child or change beneficiaries.