College Plans That Save Headaches as Well as Money
These estate planning vehicles may help
on August 23, 2017
Updated on June 23, 2022
If you’ve been living in a cave, here’s a news flash: College costs have gotten really expensive. And yet, those with a college education continue to out-earn those without a degree. If you’re saving for college expenses, there are savings and investment options to get more bang for your postsecondary buck through tax advantages, particularly if you’re able to start planning well ahead of the first day of classes.
“There are a lot of factors to take into consideration. Each family has its own needs—their children are different, the wealth of whoever’s making the gift—so it’s different for everyone,” says Wendy E. Hartmann, an estate planning attorney in Glendale.
UTMA (Uniform Transfers to Minors Act) Account
This is essentially a trust account that’s less onerous to manage than a typical trust, and you retain control over the assets in the account until your child reaches legal age (usually 21). You can transfer up to $14,000 per year per parent into the account gift-tax-free (as with any of the listed savings vehicles), and any income produced by the assets will be taxed at your child’s tax rate. Transfers are irrevocable, and upon attaining the age of majority, the account belongs to your child. While the trustee calls the shots, they can make sure the money goes to educational purposes, but once the beneficiary turns 21, they may make different choices. The account will be counted as a student asset for financial aid application purposes, assessed at a 20 percent rate (higher than the 5.64 percent rate assessed for parental assets).
“One of the reasons we sometimes frown on [UTMA] is that, at 21, the account reverts to the child. They gain control at that point, and it can’t be extended,” Hartmann says. “You’ve got to know that the money will go toward education and the care of the child. When they get to a mature age, you have to talk to them about why it’s there and how to use it.”
Coverdell Education Savings Account (formerly, Education IRA)
Money placed in a Coverdell account accrues tax-free and can be withdrawn tax-free when used for qualified education expenses. Funds from the education savings plan may be applied to both college and eligible K-12 expenses. There are income limits to who may be eligible, as well as contribution limits of $2,000 per student per year. Contributions must occur before the beneficiary reaches 18, and must be used by age 30. Like a 529 plan, withdrawal for a non-qualified purpose will be subject to federal (and possibly state) income tax on the earnings, as well as a 10 percent penalty. Unlike a 529, a Coverdell affords more individual control over investments in the account. A Coverdell account is transferable to another family member. Coverdell funds will be counted as parental assets for federal student aid application purposes.
These tax-deferred retirement savings accounts can be used for college savings, as well. Withdrawals from IRAs are exempt from penalties if used for educational expenses from an account at least five years old, and any remaining funds can be retained as a retirement account with no penalty. In addition, an IRA is not counted as an asset for financial aid purposes, although withdrawals will be counted in the following year’s application as student income. Withdrawals of contributed amounts may be taken tax-free, but any earnings will be taxed if you’re under 59. There are contribution and earnings limits to use a Roth IRA, and you must be earning income to make a contribution.
Savings bonds are still around, and can offer some advantages when used for college savings. Series EE and Series I U.S. savings bonds offer tax-free interest when redeemed to pay for qualified educational expenses. Savings bonds are a very safe investment in that the return is guaranteed and not dependent upon market influences. Bonds are also replaceable if lost or stolen. Bonds are counted as assets of the bond owner for financial aid purposes.
“Typically we guide people to the 529 plan because it’s the simplest,” Hartmann says. “It’s a good way to get a significant amount out of an estate all at once.”
Considered by many to be the gold standard in college savings strategies, a 529 is a state-sponsored fund that allows you to grow earnings and make withdrawals for qualified higher education expenses tax-free. You can bundle up to five years of your gift tax exclusion to make a large lump-sum contribution. Unused funds may be transferred to other family members without penalty, and have no time limit on their use. Funds withdrawn for non-qualified purposes will be subject to taxes and penalties. 529 funds will be counted as parental assets for financial aid application purposes. If your student receives a scholarship, an amount equal to the scholarship may be taken from the 529 account without penalty (but subject to income tax on earnings).
“The other good thing about a 529 is that, if it isn’t all used up by one child, it can get passed on to another family member,” Hartmann adds.
Of course, you can always just stash money under the mattress, too.
Whatever strategy you decide on, keep in mind that college planning has tax and estate planning implications, often involving sophisticated analysis of intersecting areas of the law. Hartmann says it’s important to seek a knowledgeable advisor. Consider consulting a tax attorney or estate planning attorney in your area.