StreetSmarts: Demystifying College Savings Vehicles

Perhaps you’re well aware at this point of how important it is to save for college for your children if you’re able to, but you’re feeling a bit daunted by the various options out there… beyond just putting money under your mattress, or letting it build in a savings account. Then today’s StreetSmarts episode is for you—it’s all about demystifying the various college savings vehicles. And by the way, any saving or investing is better than not saving or investing at all, and that should be made clear first and foremost. But, I’m going to go over some pros and cons to hopefully take some mystery out of your decision making.

Before I get to talking specifics, I just want to describe the factors that tend to differ between the options, in order to give some background context. Account types can differ in how they’re treated from a tax perspective—and this refers to how the funds are taxed as they grow, how they’re taxed when they’re eventually distributed from the account, and whether contributions made are tax deductible. Further, accounts can differ in how they’re counted in a financial aid assessment of expected family contribution (or EFC), meaning some are considered parental assets and some are considered the child’s assets. And this is important because parent and child owned assets are treated very differently in an EFC calculation. Accounts can also differ in the rules surrounding how the funds may be used. Speaking of rules, they’re also different in what they may be invested in. And very importantly, they differ in their contribution limits.

So, let’s get started with UGMA and UTMA custodial accounts, but we’ll focus on UTMA because these have superseded UGMA accounts in most states. Standing for Uniform Transfers to Minors Act, these custodial accounts allow parents to put money away on behalf of a child. While the parent can be the custodian on the account, for the purposes of financial aid, these accounts are considered child assets. This is one downside to UTMA accounts because for expected family contribution calculations for financial aid, child assets are counted at 20%, whereas parental assets are only counted at roughly 5%. Another con worth mentioning is that earnings on growth in the account are taxed according to a less favorable “kiddie tax” rule.  While a perk of UTMA accounts is that the funds do not have to be used for education expenses, providing for more flexibility, this could also be seen as a drawback because the funds really can be spent at the child’s discretion at age 18 or 21. So, as the parent, if your goal was to help pay for your daughter to go to college, and instead she decides to buy a car with the funds, that is the control you relinquish with an UTMA account. Further, these accounts cannot be transferred from one child to another sibling. On the plus side, distributions from these accounts are exempt from income taxes, and because the accounts are self-managed, you can invest them however you’d like. In terms of contributions, there is a $15,000 limit per individual, or $30,000 if married, without incurring a gift tax.

Switching gears, let’s talk about Coverdell Education Savings Accounts, which are established in a trust or custodial account on behalf of a child. Contributions are limited to $2000 per year per child, regardless of the number of parents or grandparents contributing to the account.  Although contributions are not tax deductible, earnings do accumulate tax free, and when distributions are made for qualified education expenses, they’re free of income taxes as well. Now when I say qualified education expenses—CESAs actually aren’t just limited to higher education tuition—they can be used for private elementary and secondary education, and can also be used to cover room and board expenses. One important distinction about these education savings accounts are that they’re subject to income limitations set by the IRS. Further, all funds must be used before the student reaches age 30, or anything remaining will be distributed, and the earnings are subject to income tax and a 10% penalty. To prevent this, though, the account owner is allowed to change the beneficiary to another family member.

Now I’ve intentionally saved the best for last: the Section 529 Plan.  There are actually two types of 529 plans, and every state offers at least one of the types. There are the slightly more restrictive pre-paid tuition plans, and then the more appealing college savings plans. Pre-paid tuition plans sell “units” of tuition at specified state schools and 270 private universities. Pre-paid tuition plans are thought of as “riskier” because pre-paid plans are often only of value if you are certain your child will attend an in-state school or specific private university.  However, they are less risky in the sense they sometimes offer a state-guaranteed return on investment. While most of the plans do allow funds to be used for out-of-state college tuition, there is often an accompanying penalty. College savings plans, on the other hand, do not restrict where the student goes to school, and they do not only apply to tuition and fees. They can also be used to over things like books, supplies, and room and board. Regardless of the type of 529 plan, there are several advantages. All earnings growth is tax deferred, distributions are exempt from income taxes, and assets are considered parental assets, not child assets, for the purposes of the financial aid calculation for expected family contribution. In other words, 529 assets are counted as the parents’, so they are part of the approximately 5% rate of inclusion, not 20%. You can also switch the beneficiary of a 529 without any penalties if the new beneficiary is a relative of the original beneficiary. The $15,000 contribution limit per individual (or $30,000 if married) stands for 529 plans too, but they have a special advantage of being able to be super funded. This means an individual can make a $75,000 (or $150,000 if married) contribution in one year and stretch the contributions over five years without triggering the gift tax reporting limit. Furthermore, 529 plan contributions are actually deductible to the contributor on the state level up to $10,000, and there is no income limitation like there is with CESA accounts described earlier. Now 529 plans do typically have limited investment options, usually limited to a series of mutual funds, unlike UTMA accounts which can be invested however the owner chooses.

As I said earlier, any saving or investing for the future is better than no saving or investing for the future, but hopefully this sheds some light on the advantages and disadvantages of the different saving vehicles. 529 plans, which have become increasingly popular and common in recent years for good reason, deserve a StreetSmarts of their own, so be on the lookout for that. For now, thank you for tuning in to today’s episode to compare some of the various college savings options out there.

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