Generally, there are four ways to save for college:
- UTMA (Uniformed Transfer to Minors Act) or UGMA (Uniformed Gift to Minors Act) accounts
- Pre-paid tuition plans
- College savings plans
- Coverdell Education Savings Accounts (ESAs)
If you don’t use any of these options, you can also elect to pay for college out of cash flow when the time comes. Let’s look at each of these options, how they work, and their benefits and pitfalls.
UTMA or UGMA Accounts
With these accounts, you make an irrevocable gift to an account for the benefit of the child. Currently, each parent may contribute up to $14,000/year to each child without worrying about gift tax issues. Technically, the child owns the account, and when he/she reaches the age of majority, the account gets transferred into his/her name, and he/she is free to do whatever he/she wants with the funds (which can be a risk if your child decides to buy a Porsche instead of attend college). The age of majority varies by state.
There is no limit on the amount that may be saved in an UTMA or UGMA account. Since the amounts transferred to the UTMA or UGMA represent an irrevocable gift, the donor is also reducing the amount of their estate with each contribution (which may be a benefit depending on the size of the estate).
You have the ability to invest in anything you want, and are not limited to the choices offered by a particular sponsor (see College Savings Plans). The funds can be used for anything – books, fees, meal plan, tuition, transportation – and are not limited to “qualified educational expenses.” Monies may be withdrawn for whatever reason, and taxes may apply if securities were sold at a gain to fund the distribution.
If the investment income is more than $1,900, and your child is under age 18 (or in some cases under age 24), the excess may be taxed on the parents’ return. As this can be complicated, we recommend that you discuss taxation of these accounts with your tax advisor.
Pre-paid Tuition Plans
A pre-paid tuition plan is exactly that – you decided to purchase, over time, the cost of tuition at an in-state school based on today’s dollars. In other words, you lock in the cost of tuition for the future based on today’s rate. If the cost of a four-year state school is $40,000 today, and your child is three, you are purchasing the tuition for $40,000, even though in 15 years it might be $80,000.
Each pre-paid tuition plan allows you to decide “how much school to buy” – two years, four years, five years – and then how to pay for it (over what time period). Pre-paid tuition plans fund only tuition and required fees – not books, a new laptop or any other “qualified education expense.” If your child decides not to attend college, the funds can be transferred to another family member.
If your child attends a private school or an out-of-state school, you will receive the “average” in-state tuition. In most states, you may also elect to transfer the value of the pre-paid tuition plan to a College Savings Plan.
Pre-paid tuition plans are available for purchase only at certain times of the year and vary by state. Check with your state’s provider to see when they are available.
College Savings Plan
Similar to a pre-paid tuition plan, but different in a few ways:
- Like an IRA, money in this plan grows tax-deferred. Distributions used to pay for “qualified education expenses” may be withdrawn tax-free, and include more than just tuition and required fees.
- The funds may be used for any college or university as long as it’s accredited by the Department of Education.
- Unlike the pre-paid tuition plan where the state invests your money, you make the investment election. Two options are available – aged-based portfolios that are tailored to the student’s expected year of enrollment, or a portfolio that you create based on the investment choices offered.
- As with the UTMA or UGMA, you can contribute up to $14,000/year to the College Savings Plan; although you are allowed to “front-load” up to five years of contributions ($70,000) at once (and then not contribute again until year six). States also limit the amount that may accumulate in the plan — again, it varies by state, so check with the College Savings Plan provider. Some states allow a state income tax deduction if you invest in a College Savings Plan offered by that state.
Enrollment is open all year.
Coverdell Education Savings Account (ESA)
Again, they are similar but distinct from either the Pre-paid Tuition Plan or the College Savings Plan:
- Coverdell ESAs can be used for all years of education, not just college; and those distributions, if used for “qualified education expenses” can be withdrawn tax-free.
- Contributions are limited to $2,000/year.
- As with the UTMA or UGMA, you can invest the monies as you deem appropriate.
- Contributions may only be made for a child who is under 18 (or has special needs).
- All monies must be withdrawn from the account once the child reaches 30 (and if not used for “qualified education expenses,” subject to a 10% penalty on the earnings and are also taxable).
- Your MAGI (modified adjusted gross income) must be under $110,000 (single) or $220,000 (joint) in order to be eligible to contribute to a Coverdell ESA.
Covering the Cost From Cash Flow
If all else fails and you have not planned by saving money along the way to send your child to college, you can always pay the associated costs from your discretionary cash flow. This is perhaps not the best option, but it’s an option nonetheless.
Which Option is Best for You?
As we have seen, there are a variety of ways to save for your child’s education. UTMAs and UGMAs are the most flexible because you can invest in anything and aren’t limited to a sponsor’s offerings, but are risky because the child owns the account once he/she reaches the age of majority. You can put away a good deal of money (it’s not capped like the College Savings Plan), but in most cases, the “extra” earnings will appear on your tax return.
Pre-paid tuition plans are great, if you can guarantee that your child will attend an in-state public school. We have found that they are not so great if your child attends a private or out-of-state public school because of the limited amount of “reimbursement” towards tuition. They are flexible in that the funds can be transferred among family members. But, enrollment is not available all year.
The College Savings Plan is more flexible than the Pre-paid Tuition plan, and it covers more than just tuition and required fees. You can also contribute quite a bit to the plan, but have limited investment options. If your state allows for an income tax deduction for contributions made, that is an added benefit. They are flexible in that the funds can be transferred among family members, and enrollment is always available.
The Coverdell and the UTMA or UGMA are the only options that can cover private K-12 school, but your income must be under certain limits in order to contribute, and the contributions are limited, too.
There is no one-size-fits-all approach to saving for college. Please speak to your Wealth Manager to discuss which option is best for you and your family.
Copyright: karenr / 123RF Stock Photo