The choices for college funding are varied and no one solution is right for everyone. Depending on your time horizon, tolerance for risk, income and estate tax situations, cash flow restrictions and what level of higher education you want to fund any of the following may be viable choices:
529 College Savings Plan
529 college savings plans are state sponsored but you can invest in a plan sponsored by any state. The advantage of “529” college saving plans is that they allow the investments to grow tax-free as long as they are eventually used for approved education expenses. These include tuition, room and board, travel and certain costs at any college, university, community college, accredited online college degree program or qualified trade school. If the original beneficiary does not use any or all of the funds in the account it is possible to change the beneficiary to another family member. Section 529 plans also provide favorable federal estate and gift tax provisions.
UTMA (Uniform Transfer to Minors Act)
Any adult can establish a custodial UTMA account for a minor. An UTMA has a couple of advantages: 1) the custodian has complete discretion as to how the money is invested (as opposed to the limited choices in some state’s 529 plans) and 2) the money contributed to an UTMA does not have to be used for college. The account can be funded using the annual gift exclusion which will allow two parents (or grandparents) to give a combined gift of $26,000 per year without gift tax, either using cash or other appreciated assets. 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 other downside to these accounts is that the money is legally the child’s when he/she reaches the age of majority (18 to 25 depending on the state).
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 account can be funded using $2,000 of the annual gift exclusion as long the parent’s income is under cetain limits. Earning on the funds in an ESA are tax deferred and tax free if used for “qualified education expenses”. ESA can also be used for virtually any higher education costs including K-12 elementary and secondary education.
Series EE Bonds
The interest on EE bonds is federally income tax free if an amount equal to the proceeds is used to pay college tuition and fees based on certain IRS rules. Unlike Coverdell or 529 Plans the saving bond exclusion only covers tuition and fees-not other qualified education expenses.
Another option is to simply save money in an investment account with the intent of using the money for college funding. This gives a parent the flexibility to use any excess savings for other purposes if the money is not required (e.g. the child does not go to a private university or gets a scholarship). Any income and gains would be taxed at the parent’s tax rates depending on who sets up and controls these accounts. Another advantage to using personal savings for college is that if you are trying to remove assets from your estate to minimize potential estate taxes you can pay college expenses directly to the school (as opposed to writing the check to the child who then pays the school). This payment is not considered a gift for purposes of the annual gift exclusion and effectively reduces your estate.
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.