In the past, UGMA's were the way to fund your child's college tuition. Now 529s are all the rage. We all want to fund our child's education as tuition for colleges increase an average of 5.5% a year. So what is the best way?
529s are named after its section of tax code and allow families to save with after tax funds without the earnings being taxed as long as the funds are ultimately used to pay for 'qualified expenses'- tuition, books, room & board, i.e-education expenses. The funds will grow usually free from federal and state taxes. 529s allow most anyone from grandparents to aunts and uncles to family friends to contribute to the account.
You don't have to open the plan in the state you live or the state where the child lives- although you may lose a chance at a state tax deduction by choosing an out-of-state plan. Almost all states have their own plan and they can differ greatly. There are many sites out there that compare the states' plans. Check out this one from Savingforcollege.com.
As for the state tax deduction, thirty-three states and the District of Columbia give residents a state tax credit or deduction if they invest in their state’s 529 plan. Five states — Arizona, Kansas, Missouri, Montana and Pennsylvania — offer a state income tax deduction to residents for any state 529 plan contributions.
It is also a good way for grandparents to bequeath assets while still alive. Since few states allow a tax deduction to another state's 529, an easy solution is for the grandchild to have multiple 529 accounts with different owners. So grandpa can create an account for his grandchild and receive the state tax deduction. Meanwhile mom and dad can create another account for the same grandchild and deduct any contributions they make into their account.
You can put up to $15,000 annually into a 529 plan for each child (or $30,000 if your spouse joins in the gift) without incurring the federal gift tax. Or you can drop $75,000 into the account at one time and average the gift over five years.
If your child does not attend college, you can transfer the funds to another family member and preserve the tax benefits. If that is not an option, you can withdraw the money and pay income tax and a 10% penalty on the earnings. Unlike other education savings programs, 529s let families participate regardless of income, and the states set a high ceiling on contributions.
Benefits of a 529:
Tax-free growth on contributions.
Tax-free withdrawals on qualified educational expenses.
Most states offer state income tax deductions or credits.
Beneficiaries my be changed to another person easily.
No federal tax reporting requirements.
No income or age restrictions.
Account stays under control of the participant (typically a parent) not the named beneficiary (typically a child).
Disadvantages of a 529:
Money must be used for qualified educational expenses or is subject to federal income tax and a 10% penalty upon withdrawal.
Investment options are limited.
No guarantee of return.
Subject to account management fees.(Source: Doughroller)
UGMA and UTMA Custodial Accounts
Years ago, one of the best ways to save for college was with a custodial or minor’s account, known as an UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) depending on your state of residence. These are custodial accounts because the assets belong to the minor listed on the account. The parent will maintain control until the minor reaches the age of majority in their particular state. Lastly, since it's in the student's name it will affect the amount of federal aid your child qualifies for when filling out the FAFSA.
Remember: the money belongs to your child, so at age 18 or 21, whatever the age of majority is in your state, they can use it to pay for college... or a new car. Which is one of the major drawbacks. The money becomes there's and the parent has no control how its used.
After recent tax changes (called the Kiddie Tax) these custodial accounts became less attractive for most families. Under current law, the account’s earnings above a certain level are taxed at the parent’s highest marginal rate instead of the child’s lower rate, until the child’s 24th birthday. For higher-earning parents, that means one-third of your yearly account growth will go to the IRS instead of the college of your choice.
Every child under 19 years old (or 24 for full-time students) who files as part of their parents’ tax return is allowed a certain amount of “unearned income” at a reduced tax rate. So for example, the first $1,050 is considered tax-free, the next $1,050 is taxed at the child’s bracket, which is 10 percent for federal income tax. Anything above those amounts is taxed at the parents’ rate, which may be as high as 35 percent. This exemption is per child, not per account.
One positive of the UGMA/UTMA over the 529 is that if you oversave and have funds leftover after graduation, you can use those funds for anything from a down payment on a house to a new car. With a 529 plan, any unused funds will be taxed and penalized.
Custodial account holders can transfer those assets into a Custodial 529 Savings Plan. The money will grow tax-deferred, unlike an UGMA or UTMA. You’ll also minimize the negative financial aid impact because 529s are treated much more favorably. Before you liquidate the investments in an UGMA or UTMA, however, check on whether you’ll incur any early withdrawal penalties and be aware that you may owe taxes on your capital gains.
Funds do not have to be used on educational expenses.
No income restrictions or contribution limits.
Variety of investment options available.
Funds can be used for any purposes.
Growth on the funds is taxed at the child’s income tax rate.
The child can make decisions–even bad ones–with the funds when they’re of age.
You may not change beneficiaries.
Counted as an asset of the child when applying for student aid, making it harder to receive funding.
Other Strategies for Saving for Education
We all know Roth's allow you to invest after-tax funds for retirement and grow tax free. But Roth IRAs also allow you to make withdrawals tax- and penalty-free to pay for qualifying educational expenses after five years. That makes it an appealing way to hedge your bets: If you’re child doesn’t go to college, you can still use the funds for your retirement.
The problem with this method is that there are income and contribution limits. Single taxpayers earning more than $137,000 per year are not eligible ($203,000 for married couples), and you can only contribute $5,500 per year for 2018 and $6,000 for 2019 (those over 50 years of age can add an additional $1,000 contribution).
Prepaid College Tuition Plans
Prepaid plans allow you to pay for tuition now at the current prices. Why would you do this? As mentioned, tuition increases at a rate of over 5% per year when looked at over a 10 year period. This will protect you from these exponential tuition increases.
More than a dozen states offer prepaid tuition plans, though some are currently closed to new enrollment. Like 529 college plans, gains in these plans are also usually exempt from federal taxes.
Coverdell Education Savings Account
A Coverdell ESA is very similar to a 529 account. You receive tax advantages when funds are used for education expenses and the parent is the owner, not the child (so less of an impact on financial aid).
The difference lies in the fact that Coverdell's can be used for any education expenses, such as private school from kindergarten up through high school and college. Another difference is the contribution limit of $2,000 per year per child. Lastly, there is an eligibility phase out starting at $110,000 for single tax payers ($220,000 for married).
You can use the 2K Rule to save: Simply multiple your child’s age by $2,000 to stay on track to cover half the average cost of a four-year, public university. So for example, a ten year old should have 10 x $2,000, or $20,000.
And remember, start early to allow those monies to compound. Saving just $50 per month from birth will give you $20,000 by age 17 (assuming a 7% return). But it's never too late to start saving.