After the lazy days of summer, the Fall is often a time of renewed focus on planning and project completion before year-end. To that end, if getting serious about saving for your kids’ college is one of your projects, there are several different account types to consider.
Each has its own advantages and disadvantages. This article summarizes several of the most common account types and one less common one.
Also called a college savings plan, the 529 plan is a popular and flexible college-savings vehicle. The owner (often a parent) can contribute a large amount to the account (after-tax), up to $28,000 a year per couple in 2013 without filing a gift tax return (up to 5X this amount by filing a gift tax return with a special election). The owner retains control over the account and can switch beneficiary to another child, another relative or themselves if circumstances dictate. The earnings grow tax-free and withdrawals are tax-free as long as used for qualified education expenses (e.g., tuition, books, room & board). 529 plans are typically associated with different states, but can be used for any accredited college. Some states offer state tax deductions for contributions to the plan (California does not). The downside of using this type of account is that the money must be used for college expenses, otherwise there is a penalty and tax due on any withdrawals. Therefore, you don’t want to over fund this type of account. Also, some states plans have high fees and mediocre investment options, so it’s worth researching different states’ plans to make sure you are choosing a low-cost one with decent investment options.
Coverdell Educational Savings Accounts (ESAs)
This type of account is somewhat more limited in that you can only contribute up to $2,000 per year and you can’t contribute if you make more than $220,000 as a couple (nothing says the child can’t contribute to the account though). Money contributed after-tax grows tax-free and withdrawals are tax-free as long as used for education purposes. There are two main benefits of this type of account: money in the account can be used for pre-college qualified education expenses and the investment options are anything available at the custodian. However, the money must be used by age 30 or it becomes the money of the beneficiary. Given the small contribution limit, most families will find this type of account inadequate for their college savings goals.
Uniform Trust for Minors Act (UTMA)/Uniform Gift to Minors Act (UGMA) Accounts
This type of account is an asset of the child, held in custody by an adult until the child reaches age 18 (or 21 in some cases). Assets in the account are taxed at the child’s tax rate, so tax savings are lower than with 529s and ESAs, which grow tax-free. Investment options are only limited by what is available at the custodian. Furthermore, because the account is an asset of the child, it is counted at a higher rate in the financial aid calculations than if it were an asset of the parent (as are 529s and ESAs). This could reduce the amount of financial aid available to the child. Furthermore, the account becomes the asset of the child at age 18, at which point they can choose to do with it what they want, which may not be what the parent intended. There are no limits on how much can be contributed to this type of account.
A bit unconventional for college savings, but with the added flexibility of not being required to be used for college, a Roth IRA, either of the parent or child, is an additional college savings vehicle. Up to $5,500 (2013) can be contributed each year (after-tax) and contributions then grow tax-free and no taxes or penalties are due upon withdrawal as long as they are used for college expenses. Furthermore, after 5 years, original contributions can be withdrawn without penalties regardless of age. If the child has earned income, an account can be set up in the child’s name. If not, the parent can contribute to their own Roth IRA (as long as income falls beneath certain thresholds and if not, a Roth conversion can be done). However, I only recommend parents pursue this strategy if they don’t need to be contributing to an IRA to meet their own retirement savings goals. A Roth IRA is particularly attractive is future funding sources for college are highly uncertain (e.g., a grandparent might step in to pay for college) because the money can always be kept in the account for retirement if not required for college.
In summary, each type of account has its own advantages and disadvantages so it’s important to consider your goals in saving for your child’s college education. Of the more traditional college savings vehicles, I tend to prefer the 529 account due to its higher flexibility, control and high contribution amounts. However, for certain clients, I like the Roth IRA option as the money can be used for retirement if not required for college.