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Saving for College: What Are My Options?

May is sometimes celebrated as 529 month (because May 29 is 5/29…clever, no?). In the spirit of this celebration, I’m going to dedicate this month’s Wealth Management 101 to college savings.

In my practice, college savings is a very common goal for parents and grandparents.

With college costs continuing to rise faster than inflation, and the value of a post-secondary education undisputed, saving for higher education is key to your child’s future.

This month I’ll walk you through the various vehicles available and the pros and cons of each.

What I won’t address is how much to save.

That’s a different animal, and you can find information on setting savings goals elsewhere on my blog.

Savings or Investing Account

Saving for college does not have to be done using an education-specific account type; you can simply put money into a savings account or investing account.

By doing so, you’ll make sure that you can use those funds for any purpose and at any time.

This may be important if you don’t have the resources to dedicate dollars to a specific goal in an account with strings attached.

However, you give up potential tax benefits and may miss out on some asset transfer opportunities.

Read: How Do Taxes Work?

UGMA/UTMA

UGMA stands for Uniform Gift to Minors Act, and UTMA stands for Uniform Transfer to Minors Act. Both refer to the legislation of the same name that created the UGMA/UTMA account type.

For simplicity’s sake, I’ll refer to these as UTMAs for the remainder of this article.

A UTMA has two parties: the trustee (an adult) and the beneficiary (the minor).

Minors are barred from owning property, and thus financial assets must be held in trust until they reach the age of majority.[1]

In general, a UTMA can be funded by anyone, and the trustee controls the assets until the minor attains majority.

UTMAs are subject to the kiddie tax, where taxes may be due if unearned income in the account totals more than $2,200.

Also, control of the account must be turned over to the minor when they attain the age of majority.

These two elements make a UTMA less-than-ideal for college savings. These accounts are much better for outright gifts to the child.

Coverdell ESA

A Coverdell Education Savings Account is another option. However, with college costs rather robust, this account may not get you where you need to be.

Like a UTMA, there are two parties to this account type: the custodian (or trustee, usually the parent) and beneficiary (the child).

The assets are considered the property of the custodian and subject to their sole control regardless of the age of the child. The single biggest advantage Coverdell ESAs have over Section 529 Plans (discussed later) is the ability to choose nearly any investment you wish to own.

That might include mutual funds, exchange-traded funds, individual bonds, and/or individual stocks.

Read: Risk Tolerance: What is it? Why does it Matter?

 

The investments grow tax-free and remain tax-free if they are used for qualified education expenses.[2] They can also be rolled into a Section 529 Plan if that suits the goals of the parties.

Now the downsides.

A Coverdell is limited to contributions of only $2,000 a year, meaning you may not be able to save enough to cover all college expenses.

Further, high income earners[3] are barred from contributing to these accounts.

If the funds are not used by the time the beneficiary turns 30, the account must be distributed to the beneficiary.

Section 529 Plan

The most well-known and popular option is the Section 529 Plan, often just called a 529. These plans were created by Section 529 of the Internal Revenue Code.

Unlike UTMAs or Coverdell ESAs, 529 plans are administered by each state, instead of being set up by an individual.

Like the other two account types discussed above, there are two parties: the participant (usually the parent) and the beneficiary (the child).

The assets are considered the property of the child but are subject to the control of the participant.

All growth is free of federal taxes as long as funds are used for qualified education expenses.

 In addition, if you live in a state where there is state income tax, your 529 plan contributions may be deductible from your state income taxes.

One of the biggest advantages of the 529 is that there are very high limits on annual contributions[4] and no limits on the income of the donor. In addition, anyone can put money into the plan, making it ideal for gifts from others.

That means a family could choose to frontload their savings in early years to take advantage of long-term compounding or use the account as a lifetime gifting or asset transfer tool.

Another great feature is that there is no age limit on beneficiaries.

Unlike with a Coverdell or UTMA, there is no deadline to distribute funds or turn the account over to the beneficiary’s control.

A drawback of 529s is that investing choices are limited.

Each plan has a menu of options to choose from, much like your 401(k).

Another disadvantage is that each plan will differ based on the state that administers it, meaning you’ll have to do quite a bit of research to know which plan works best for your situation.

Fortunately, there are websites like SavingForCollege.com that aggregate information and offer free calculators and comparison tools.

There is no silver bullet solution that will meet all your post-secondary needs and goals.

Most clients use a combination of account types.

 A good Financial Advisor will take the time to understand what you want to achieve and what resources you have available, and then help put that information in the context of each investing option to pick the right mix of accounts to set you on the path to saving for your children’s higher education.

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[1] Age 18 or 21 depending on state of residence.

[2] Also included as allowable expenses are transportation, computers, and other technology like internet access, so long as these are used during any year the account beneficiary is in school.

[3] Those earning a Modified Adjusted Gross Income of over $220,000 for couples or $110,000 for single tax payers

[4] Contributions from a single donor that exceed that annual gift tax exclusion amount may be subject to gift taxes.

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