Generally speaking, saving in tax advantaged segregated accounts to fund a child’s higher education can be done in three different ways: trust accounts created under the Uniform Gifts to Minors Act (UGMA); Coverdell Education Savings Accounts (formerly known as Educational IRA's); and the Section 529 College Savings Plans.
UGMA Trusts:
These custodial accounts have been used to save for children's educations for many years due to their tax-advantaged status. The accounts have the following attributes:
- For children who are under 19 (or 24 if a full-time student) the first $900 in unearned income in the account is tax free, the next $900 is taxed at 15%, and the rest is taxed at the parent's marginal rate.
- For children age 19 and older who are not full time students (or age 24 and older and full time students) all taxable income is taxed at the child's rate.
- The custodian has a complete range of investment choices.
- Because the trust is actually owned by the child, at the age of majority funds can be used for whatever the child wishes notwithstanding the parent’s desire that the funds be used for education purposes.
- For families with modest incomes, the savings could cause a student to qualify for less aid since UGMA trusts are a student asset and thus assessed at a higher rate than 529 savings plans and education IRA's which are parental assets.
- Assets in UGMA trusts can be transferred to 529 savings plans with some restrictions (see below).
Coverdell Education Savings Accounts (CESA):
Coverdell ESA's (formerly known as Education IRA's) have been a poor relation to the 529 College Savings Plans due to the very small ($500) annual contribution limits and the inability to contribute to both a Coverdell ESA and a 529 savings plan in the same year. Tax legislation passed in 2001 remedies these problems.
- Annual contributions from all sources are allowable up to $2,000 per child. Contributions can be made to both a CESA and a 529 plan in the same year.
- There is no deduction when money goes into the account, but it does grow tax deferred.
- Tax-free withdrawals can be made to pay for private elementary and high school expenses as well as for college expenses.
- Hope or Lifetime Learning tax credit can be taken in the same year a Coverdell Education Savings Account withdrawal is made. Note: Withdrawals from all sources must be coordinated since the same expenses cannot be used to qualify for more than one credit or tax free withdrawal.
- The custodian has full discretion on the investments.
- The parent or other responsible person controls the account until it is used for qualified education expense or until the beneficiary reaches age 30. Funds remaining in the account must be distributed within 30 days of the beneficiary reaching age 30. If not used for qualified higher education expenses, distributed earnings are subject to tax and a 10% penalty plus ordinary income taxes.
- Funds can be transferred to another family member under age 30.
- Joint filers can contribute the maximum $2,000 only if adjusted gross income (AGI) is below $190,000 ($95,000 for single filers). If earnings are above that amount, then contribution amounts are reduced and are completely phased out for AGI more than $220,000 ($110,000 for singles).
- Coverdell Education Savings Accounts are considered an asset of the account custodian, typically the parent, resulting in more aid. This lessens the impact on financial aid decisions.
State Sponsored Section 529 College Savings Plans:
529 plans are sponsored by most states. There are two types: College Savings Plans and Prepaid Tuition Plans.
College Savings Plans are defined by the following:
- Contributions to a Section 529 plan, regardless of your annual income or age, can be for the benefit of anybody, including grandchildren, nieces and nephews, your own children, or your neighbor from down the street.
- In most states, you can contribute as much as $300,000 per beneficiary into a 529 Plan. Funds grow free of federal income taxes and in many states free of state taxes. Some states also allow a deduction from income for residents contributing to plans. Regardless of which state's plan you use, the invested funds are available for education expenses at colleges and universities nationwide.
- The account is professionally managed according to an investment program you select with the initial contribution.
- The account owner maintains control over how the assets are invested and when distributions are made, ensuring that the assets are used for their intended purpose.
- Withdrawals used for qualified education expenses, such as tuition, room and board, supplies and equipment, are not taxed.
- Funds not used for a beneficiary's education can be transferred, with no tax penalty, to another family member of the beneficiary. Family members include siblings, first cousins, children, nieces, nephews, or a spouse. There is no age limitation on when the funds can be used for education.
- Investments in section 529 plans qualify for the federal gift tax exclusion. A special provision allows an individual to contribute up to $65,000 in one year to a plan for a beneficiary and treat the contribution as if it were made over five years so as to qualify for the annual exclusion. A couple could contribute $130,000 per beneficiary; thus the plans can be used in estate planning.
- Money can be transferred tax free from one qualifying program to another for the same beneficiary.
- Participants have the opportunity to change their investment strategies once each year.
Prepaid Tuition Plans are defined by the following:
- Contributions can be made for the benefit of anybody, including grandchildren, nieces and nephews, your own children, or your neighbor from down the street.
- In most states, you can contribute as much as $300,000 per beneficiary into a 529 Plan. Funds grow free of federal income taxes and in many states free of state taxes. Some states also allow a deduction from income for residents contributing to plans. Regardless of which state's plan you use, the invested funds are available for education expenses at colleges and universities nationwide. Note: Prepaid tuition plan benefits are generally designed to be used at in-state public universities and community colleges; however, in some cases, they can also be used at private institutions and at out-of-state public and private colleges and universities. Check the plan details for the prepaid plan in the designated state.
- Withdrawals used for qualified education expenses, such as tuition, room and board, supplies and equipment, are not taxed.
- The account is considered an asset of the parents, rather than the student, which minimizes its effect on need-based aid.
- Tuition is purchased in blocks that can be used later at one of the plan’s covered schools. If tuition rises after you have purchased the blocks, it does not matter: A semester purchased now will still buy a semester’s worth of tuition 10 or 15 years from now. Note: The plan's tuition inflation rates are based on public state school tuition increases.
- These plans do not guarantee college admission. The student must still meet academic entrance requirements.
- The program pools the money and makes investments to enable the earnings to meet or exceed college tuition increases in that state.
- Funds not used for a beneficiary's education can be transferred, with no tax penalty, to another family member of the beneficiary. Family members include siblings, first cousins, children, nieces, nephews, or a spouse. There is no age limitation on when the funds can be used for education.
- Investments in section 529 plans qualify for the federal gift tax exclusion. A special provision allows an individual to contribute up to $65,000 in one year to a plan for a beneficiary and treat the contribution as if it were made over five so as to qualify for the annual exclusion. A couple could contribute $130,000 per beneficiary; thus the plans can be used in estate planning.
- The account purchaser maintains control over the account.
- Money can be transferred tax free from one qualified state program to another for the same beneficiary, however, program requirements vary by state.
Tuition Payment Plans:
Due to the 2008 financial crisis, these programs are beginning to soar. They can be defined as follows:
- Short-term (12 months or less) installment plans which split your tuition into equal monthly payments.
- Many are interest-free but have fees or financial charges.
- These are appropriate when you can afford to pay tuition but not in a lump sum at the start of the semester.
- The following are sources of these programs:
- FACTS Tuition Management - offers tuition management and budgeting services for educational institutions at all levels. www.factsmgt.com
- Sallie Mae Tuition Pay - lets you pay your tuition bill in small, monthly installments at more than 2,500 schools nationwide. Enrollment fee is typically around $50. http://tuitionpay.salliemae.com
- Tuition Management Systems - interest-free monthly payments option allows students and families to spread educational costs over several months. Enrollment fee typically ranges from $30 - $60. www.afford.com
U.S. Savings Bonds:
Qualified taxpayers may exclude from their gross income all or part of interest paid upon redemption of qualified EE and I Bonds issued after 1989.
- The bond must be in the name of the taxpayer or taxpayer’s spouse and not in the name of the dependent. The designation of a child as co-owner with his or her parent is not permitted. However, the child may be listed as a beneficiary.
- Qualified expenses must be incurred in the same tax year as the bond is redeemed. Both principle and interest must be used for qualified expenses. If the amount exceeds expenses, excludable interest is reduced pro rate.
- Married couples must file jointly to qualify for the exemption. There are adjusted gross income levels when the excludable amount begins to be reduced until phased out completely.
- The purchaser must be age 24 or older at the date of issuance.
Transferring UTMA/UGMA Accounts to 529 Plans:
Due to the exclusion of 529 plan investment income from taxes when used for qualified education expenses, many trustees of UTMA/UGMA accounts wonder whether it makes sense to move these accounts to 529 plans. The following parameters need to be considered in making the decision:
- Money you have given your child in a custodial account belongs to the child. If you move the funds to a 529 plan you can’t later transfer it to another beneficiary, and the child still gains control at the age of majority.
- Most states (not all) will open 529 plan accounts with UTMA/UGMA designations. If you make further contributions after the transfer then these funds will also belong to the child. It can make more sense to open a second 529 account with the parent as owner and child as beneficiary to maintain control of the funds.
- 529 plans accept cash only as account contributions. Therefore, if you are transferring funds from UTMA to 529 plan, you must cash out of whatever investments you are holding in the custodial account and pay taxes on any gains before redirecting the cash into the 529 plan.
A Final Suggestion:
For an individual who has already used the gift tax exclusion for the year and wishes to contribute further to the education of another person, the tax code allows unlimited gift tax exclusion for amounts paid on behalf of a recipient directly to an educational organization so long as such amount is only for tuition payments. Amounts paid for room, board, books, etc. are not available for the exclusion.
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