College savings plans allow individuals to contribute to an account to pay a beneficiary’s qualified higher education expenses, such as tuition, fees, books, supplies, and room and board.
A person has four major investment vehicles to save for college expenses. Each one has advantages and disadvantages. It is important to consider investment options, contribution limits, control over the account, affect on financial aid and qualified expenses of the money before selecting a specific vehicle.
529 Plans
The 529 plan is probably the most well known college savings plan.
529 plans allow money to grow tax deferred and if used for qualified higher education expenses, tax free. There are not income limits to participate. Up to five times the annual gift tax exclusion ($65,000 in 2009) can be given in one year per beneficiary by each tax payer. This allows for very large contributions, regardless of income.
529 plans are sponsored by individual states and by some universities. Most use mutual funds, but some 529 plans are for prepaid tuition at State universities. If 529 funds are not used for the intended beneficiary they can be used by a family member. If removed from the 529 plan for expenses other than qualified higher education expenses, a 10% penalty plus ordinary income tax is due.
Contributions to 529 plans are made with after-tax dollars and any earnings grow tax-free at the federal level. Earnings withdrawn from 529 plans to pay for qualified higher education expenses are free from federal income tax for state-sponsored programs and programs of any eligible higher education institution.
State-tax treatment of college savings plan contributions, earnings, and withdrawals vary from one state to another. A number of states allow residents who participate in their own state’s plan to claim a partial or full state income tax deduction on contributions. In addition, many states provide residents with a state tax break on earnings distributions from 529 plans that are used to pay qualified college expenses. Check with your tax advisor for your state’s tax treatment of contributions to, and earnings distributions from, both in-state and out-of-state 529 plans.
The ESA has similar tax treatment as the 529 plan, but has some very important differences. Only $2,000 can be contributed per year per child, additionally if the donor has a high level of income they are not eligible to make contributions to an ESA. Unlike the 529, ESA funds can be used for elementary, middle, and high school expenses. ESA’s have the broadest range of investment options, as they are not limited to state specific 529 mutual funds. Also, like the 529, ESA’s can be moved to a new beneficiary but must be moved before the beneficiary turns 30.
Uniform Transfer to Minors Act (UTMA) Custodial Account
The UTMA is a special account for minors which allows permanent gifts to be made to children, allowing for a custodian to manage the account during childhood, and then becomes the property of the child when reaching 18 or 21 (depending on the State). Once a gift is made to a minor through an UTMA, the gift is completed and may not be rescinded. When the child becomes a certain age, they retain total control over the assets and do not have to use it for education. The UTMA does not provide a tax sheltering for realized investment gains and gifts to the UTMA over the annual gift tax exclusion amount ($13,000 in 2009) would be taxable gifts.
U.S. Savings Bonds
If parents purchase Series EE or I bonds, the interest is exempt from taxation if it is used to directly pay the expenses of tuition at a qualified university. Unlike the 529, this exemption does not apply to books or room and board. Tax payers cannot claim the deduction if they have an income above certain levels and filing status. Possibly the biggest drawback is the very low rate of interest U.S. Savings Bonds pay.
Contact us at Financial Life Advisors to help you review which type of college savings plan is best for you.
This firm is not a CPA firm.
Financial Life Advisors (FLA), a Registered Investment Adviser, and Jim Oliver & Associates, P.C. (JOA) are under common ownership and control. Team Oliver is used to describe collaborative services of both firms. Professional tax services are provided by JOA and investment advisory services are provided by FLA, each under separate agreements.
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