Investing in your child’s education may be the most important investment you’ll ever make. But rising tuition costs and taxes can make this a daunting proposition. To begin saving for a child’s education, there are several investment vehicles available: a 529 college savings plan, a Coverdell Education Savings Account (formerly Education IRA) and custodial accounts under the Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA).
529 Plan
A 529 plan is a flexible savings program that combines tax benefits with professional portfolio management while giving you continuing control over the funds in the account. Under the 529 plan, you work with a financial advisor to choose from several different investment portfolios. Investment earnings grow on a federal income tax-deferred basis, and distributions for qualified higher educational expenses are currently federal tax-free. The federal tax provision allowing tax-free withdrawals will expire December 31, 2010, unless it is extended. Depending upon the laws of the state in which you live, favorable state tax treatment for investing in a Section 529 plan may be limited to investments made in a Section 529 college savings plan offered by your home state.
The 529 plan allows annual contributions up to $12,000 per child without exceeding the annual federal gift tax exclusion. Contributions to 529 plans are considered completed gifts. 529 plans provide an attractive gifting program, allowing parents and grandparents to gift large amounts, thus reducing the taxable estate. You may contribute up to $60,000 in a single year ($120,000 if married and filing jointly) without incurring a gift tax as long as there are no further gifts for a period of five years.
Unlike the Coverdell Education Savings Account and custodial accounts, the 529 plan has no age limit on contributions or depletion of funds for the beneficiary in the account. Also, if a relative opens a 529 plan, the contributions are not factored in when the child applies for federal financial aid. Another attractive feature is that you can change the beneficiary at any time.
Coverdell Education Savings Account
The Coverdell Education Savings Account (ESA) offers the flexibility of shifting investment strategies at any time, allowing you to take advantage of bull markets and weather bear markets. The maximum annual contribution limit to a Coverdell ESA is $2,000. Contributions are not tax-deductible, but earnings in the account accumulate tax deferred and all qualified distributions are tax-free. Coverdell ESAs are available for full participation to contributors whose annual income doesn’t exceed specified limits ($95,000 for single filers and $190,000 for joint filers) in the year of your contribution.
Distributions can be used for more than just college; they can be used for qualified elementary and secondary expenses to include public and private schools. As noted above, Coverdell ESAs have some age limitations. The beneficiary of the account must be under the age of 18 at the time of the contribution and the account must be depleted or transferred to a new beneficiary by the age of 30. The Coverdell ESA, like a 529 plan, allows you to change the beneficiary (unless otherwise specified in the application). Excess funds not used by the designated beneficiary can be designated to a new eligible member of the family.
Custodial Accounts (UGMA/UTMA)
A custodial account gives the child ownership of the assets, but leaves complete control of the assets with the custodian until the minor reaches the age of majority. Typically, the assets in a custodial account are gifts provided by a family member and can sometimes be earmarked for specific uses, such as education, a home or a car.
There are disadvantages to custodial accounts. They don’t grow tax-deferred like the 529 plan and Coverdell ESA. Also, custodial accounts pay taxes on any realized gains in the year in which the gains are accrued. Investments which pay dividends can require the child to pay taxes in the year the dividends are paid. If a change in investment type is required, such as when a child is nearing college age or is entering college, the sale of any securities that have appreciated is a taxable event. The assets are included when determining a student’s eligibility for federal financial aid.
Begin Now
Regardless of which savings plan you choose, starting early can improve your position and may provide increased options later. When a child is very young, you may want to invest more aggressively and switch to a more conservative approach as the time when he or she enrolls in school grows closer. The type of education savings option you select should focus on the time horizon of your savings goal, the tax efficiency of each option and your desire to control the use of the assets after the child reaches the age of majority.
While financial advisors cannot offer tax advice, they can help you sort through the different features and tax advantages associated with each education savings option and decide which plan best suits your goals. IBI