Many clients want to better understand what options they have to fund future college expenses for their children or grandchildren and there are several options available to you that help can you save on taxes as well.
Below are 5 possible ways to start funding a child’s or grandchild’s college education.
1. 529-College Savings Plan—These plans are state sponsored but the money can be invested in any state plan. The advantage to “529” college saving plans allows the investments to grow tax-free, as long as they are used for approved education expenses that includes tuition, room and board, travel and other costs at any college university, community college and even some technical school it they qualify. Again this can be funded by gifts from parents or grandparents to the beneficiary, the child. The account can be funded with $13,000 per year per person without gift tax issues. There is actually a unique rule that allows the acceleration of 5 years of gifts so as much as $65,000 ($130,000 for a couple) into the account through a special federal gift tax election the first year. I don’t recommend this but it is an option. One other advantage to a 529 plan is the beneficiary can be changed to other family members, so if one child gets a soccer scholarship the 529 plan can be used for other siblings or family members.
2. UTMA- Uniform Gifts to Minors Act is a custodial account can be established for each child, typically with one of the parents as the custodian. This has a couple of advantages: 1) There is complete flexibility in how the money is invested (as opposed to the limited choices in some state’s 529 plans) and 2) the money does not have to be used for college. This can be funded by gifting the child each year up to the annual gift tax exclusion by using either cash or appreciated assets. Unfortunately the “kiddie tax” rules have changed and do not allow children to take advantage of a lower capital gains rate. As of 2008, any income received by a child even if they are a college student is taxed at their parent’s rate eliminating the advantage previously available to give them if you gift stocks or mutual funds that have gone up in value. For children who are under 19 or are under 24 and attending college only a limited amount of income is allowed before the so-called “kiddie tax” rules apply. If the child earns more than $1,900 in investment income, the excess is taxed at the parents’ rates. The downside to these accounts is that the money is legally the child’s when they reach the age of majority, so they can go out and buy a Harley with the money if they want. For this reason you may want to be cautious with how much you put into an UTMA account.
3. Coverdell Education Savings Accounts (ESA)-These used to be called Educational IRAs because they allow for a non-deductible contribution of up to $2,000 per year per child. The contribution is NOT deductible. The designated beneficiary must be under the age of 18 years of age at the time the account is established, except for a special needs beneficiary. A Coverdell ESA is a trust or custodial account set up in the United States solely for the purpose of paying qualified education expenses for the designated beneficiary of the account. In general, the designated beneficiary of a Coverdell ESA can receive tax free distributions to pay qualified education expenses. The distributions are tax free to the extent the amount of the distributions do not exceed the beneficiary’s qualified education expenses. You would have to gift this money to the parents of the child so they could set up this account as long-as their income is under $190,000 because these accounts are phases out for high income earners. Unlike a 529 College Saving Plan an ESA can also be used for virtually any higher education costs including K-12 elementary and secondary education. This may change soon depending how the new tax laws shake out.
4. Series EE Bonds-these are government bonds. The interest on the EE bonds are federally income tax free if an amount equal to the proceeds is used to pay college tuition and fees. Unlike Coverdell or 529 Plans the saving bond exclusion only covers tuition and fees not other qualified education expenses.
Another choice is to just save money in an investment account with the intent of using the money for each child’s college funding, if needed. This gives the client the flexibility to use any excess savings for other purposes if the money is not required for college (e.g. they don’t not go to a private university). Any income and gains would of course be taxed at the rate of the person who controls these accounts.
Deciding on an option that is best for you varies based on:
- How much you wants to gift each child
- Marginal tax rates of parents and grandparents
- Estate tax issues
- Time until the funds are needed
- Target amount to be in the accounts when the children start college
- Need for flexibility of the use of the money
For all of these types of accounts a reasonable investment philosophy is to use a balanced mix of stocks and bonds, with the allocation becoming more conservative as college approaches. In a 529 plan, there is usually an “age-based” option that accomplishes this result. Bedrock is happy work with clients to work their way through the maze of choices, and to advise on the best 529 plans and other vehicles once they decide on how much they want to save each year for a child or grandchildren’s college.”