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College/Education Savings Options Explained

November 26th, 2012

Education planning is one the most important things that a parent can do for a child. There are many options available, so choosing the right one can be challenging. The following information is an overview of the type of accounts available and their pros and cons.

529 College Savings Plan

This is one of the most popular options for college saving as you get a tax-advantaged account with high annual contribution limits to save in. 529 plans are offered state by state and plans can differ depending on the state. However, you don’t have to live in the state that you open a 529 plan in. For example, you can live in Florida and have a Massachusetts 529 plan. When selecting a plan, you will want to research the differences between each state as the benefits can differ with regard to state taxes and performance.

Advantages

  • You can save up $26,000 per couple.
  • The contributions are gift-tax free.
  • Lump sum of $65k can be contributed as long as it is pro-rated over a five-year period.
  • If you used for education, the withdrawals are federal income tax free.
  • The account can be reassigned to another beneficiary.
  • There is no income phase out limit.
  • The account belongs to the owner, which is beneficial for both obtaining student financial aid and retaining control of the account while the student is in college.

Disadvantages

  • If the funds aren’t used for a post-secondary educational purpose then withdrawals are assessed a 10% penalty and will be taxed as ordinary income.
  • The states select the investment menu and at this point, the choices are inadequate, making it difficult (if not impossible) to construct an optimal long term portfolio. This can result in an account that will be tens of thousands of dollars less then it could have been, which could make the difference between fully funding college or not.

Education Savings Account (Coverdell) 

This type of account has generally been phased out as a result of the emergence of the 529 plans. The $2000 contribution limit is typically too low to build a nest egg that will satisfy educational expense needs.

Advantages

  • It maintains a tax deferred status.
  • Withdrawals are federal income tax-free.
  • Owner maintains control of the account.
  • All levels of schooling can be funded by this account, unlike the 529 plan. (This is a unique benefit, and one of the few reasons to fund an Education Savings Account.)
  • A full menu of investment choices is available, allowing the owner to construct an optimal long term portfolio.
  • The account belongs to the owner, which is beneficial for both obtaining student financial aid and retaining control of the account while the student is in college.

Disadvantages

  • The maximum amount that can be contributed is $2000. That is a tax-deferred amount, but it’s hardly enough to fund the expenses of a 4 year college.
  • If the funds aren’t used for an educational purpose then withdrawals are assessed a 10% penalty and will be taxed as ordinary income.
  • There are income phase out limits which prevent you from contributing. (AGI = $90k for single and $190k for married filing jointly).

Custodial Account (UGMA/UTMA)

Although this type of account is available, it is generally used for a wider array of options than just education planning.

Advantages

  • There are no limits to contribution amounts.
  • There is a small tax benefit. i.e. the first $950.00 gain is not taxed if the child is under 19. The next $950 is taxed at the child’s income tax rate. Thereafter the taxes are the same as the parent/owner of the account.

Disadvantages

  • The contributions are an irrevocable gift to the minor. Hence the assets belong to the minor, which carries tax consequences for them.
  • The owner will give up control of the account once the minor turns 18 or 21, depending on the state. If the child is not in good standing at this time, a financial disaster can result.
  • It negatively affects the student’s eligibility for financial aid.

Custodial IRA – Roth or Regular IRA

This account is generally setup for the retirement of the minor. It does allow for early withdrawals if the funds are used for education.

Advantages

  • The guardian can establish the account and maintain control of it until the account’s termination age (typically 18 years of age).
  • If it is a Custodial IRA, then the contributions are tax deductible to the child.
  • If it is a Custodial Roth, then after dollars are used to fund the account and qualified withdrawals are entirely tax free.
  • A full menu of investment choices is available, allowing the owner to construct an optimal long term portfolio.

Disadvantages

  • In order to contribute to the account, the child has to have earned income. That means that the max that can be contributed is the earned income amount or $5000, (for 2012) whichever is lower.
  • Tax deduction is at the child tax rate which is typically low; hence it generally makes more sense to use the Custodial Roth.
  • The assets belong to the child at age 18.
  • It negatively affects the student’s eligibility for financial aid

Roth or Regular IRA

This generally holds the same advantages as the custodial IRA while offering more flexibility since control of the account remains with the parents.

Advantages

  • Control remains with the parents, giving them flexibility with regards to the use of the funds. (If the child gets a full scholarship, the parents can use the money for their own retirement.)
  • Can contribute up to $5000 ($6k if 50 or older) into a Roth or IRA. (Income phase out limits to apply.)
  • There are tax advantages to both the Roth and IRA that can be used to the owner’s benefit.
  • A full menu of investment choices is available, allowing the owner to construct an optimal long term portfolio.
  • The account belongs to the owner, which is beneficial for both obtaining student financial aid and retaining control of the account while the student is in college.

Disadvantages

  • If owner works in a company that provides a 401k or similar retirement plan, then the amount contributed may be limited or altogether not allowed for tax deductibility purposes
  • The phase out limits can prevent a tax deductible contribution to an IRA or any contribution to a ROTH. (IRA- $68k for single filers and $112 for married filing jointly. Roth- $125k for single filers and $183k for married filing jointly.)

Trust Account

A taxable account that allows provides a full investment menu and provides rules for governing how the money is invested and dispensed. Trusts are more expensive to setup than the other types of college savings accounts.

Advantages

  • A trust can be tailored to control the distribution of the assets which can help to prevent the student from wasting their college savings.
  • There is no contribution limit.
  • A full menu of investment choices is available, allowing the owner to construct an optimal long term portfolio.
  • Depending on how the trust is structured, there can be a tax benefit to the owner of the trust. Further, the dispensed trust income is generally taxed at the beneficiaries’ income rate, which is normally lower than the owner of the Trust.
  • Trusts excel when you are looking to save a lot of money (excess of $100k) for college for multiple children/ beneficiaries.

Disadvantages

  • It can be expensive to create a trust and choosing the right type of trust can be tricky.
  • A trust may or may not be tax advantageous to the owner, the beneficiary, or both.

Prepaid College Funds

These plans are offered by some states and allow you to lock in tuition rates for future college students. You pay monthly dues over a fixed period of time before your child goes to college.

Advantages

  • Tuition rates are locked-in at current rates, so you can potentially avoid paying for the increase in tuition costs.
  • You can transfer the prepaid benefit to other children. (You can cancel for a full refund if you decide you no longer want the plan, but you will have realized a major opportunity cost.)

Disadvantages

  • If the child goes to a school outside of state you funded, then the value of your investment may be seriously affected. (You can get a refund for what you paid, but you have lost the years of growth you could have had. You may also be able to apply the funds to the out of state school, but it’s normally at a reduced rate.)
  • “Guarantees” have been broken before (See South Carolina’s plan and Alabama’s plan) as a result of not of the state failing to have the funds available. So, you might not wind up getting the benefit you paid for.
    • In some states, an extra mandatory fee has been added. Prices will now reflect the cost of base tuition, “differential” tuition and mandatory local fees, all in one plan.
      • Previously, four-year university plan buyers could pick up a prepaid plan that covered only base tuition and then could choose to buy or ignore optional plans for differential tuition and local fees.

Which plan is best?

It depends on what you need the account to do. The 529 plans have a nearly ideal setup, as they were created to be the college savings plan, however they fall short when it comes to investment choice and flexibility, since the investment choices are limited and the money can only be used to fund educational expenses. IRAs and Roths provide similar advantages to 529s, but have much lower contribution limits and are subject to income phase outs, making this a less attractive option for high earners. Plus, timing your distributions from your IRA during college years can be tricky, as a special educational exemption must be used for the withdrawn funds. However, an IRA or ROTH does provide a full range of investment choices and you don’t have to use the money for only educational expenses. Finally, trust accounts may not provide tax deferral, but when properly structured, they can provide just about everything else.

When it comes to college planning, choosing the right account type can help maximize both your student’s and your own financial situation. These decisions can be made without the help of an expert, but if you are unsure as to which account to fund, we advise that you seek outside counsel to ensure that you make the best decision.