A few tax-advantaged ways to save for college exist in order to encourage families to start saving. In exchange for the preferential tax treatment, each of the investment options have restrictions or drawbacks that are important to consider before choosing an investment method. For the most part, tax-advantaged college savings options fall into one of the following three categories:
529 College Savings Investment Plans
Creatively named after Section 529 of the IRS tax code, with a 529 Plan you pay tax on the money you put in, but you don't pay tax on the the money you take out, as long as it's used for qualified education expenses. Funds can be used to pay for college-related expenses, including tuition, fees, room and board, and textbooks.
- There are no income limits; you can establish a 529 plan regardless of your income level.
- Contribution limits are high.
- Contributions can be used in any state and for qualified educational institutions.
- Anyone can contribute.
- If you don't use the money for qualified college-related expenses you will have to pay tax on the earnings plus a 10% penalty.
- It could affect your financial aid eligibility; 529 plan savings are considered a part of the parents' assets when applying for financial aid.
- Your investment options may be limited.
- You can't use a 529 plan to pay for K-12 education expenses.
A 529 plan can be a smart investment vehicle, but there are stiff penalties if the money ends up being used for something other than education. While the money could be transferred to a different beneficiary without incurring penalty, the possibility that their child will choose a path that doesn't involve post-secondary education still makes some parents nervous about investing in a 529 plan.
The penalty does not apply to scholarships, so if your child has fewer education expenses than expected due to a scholarship, you can withdraw the amount of the scholarship without incurring a penalty.
Much like the 529 plans, Coverdell accounts offer tax-free investment growth when funds are used for education-related expenses. A big advantage of Coverdell plans is that, unlike 529 plans, they can be used for certain qualified K-12 expenses. However, Coverdell accounts have lower contribution limits and impose income limitations, disqualifying higher income earners.
- Contributions can be used for qualified K-12 expenses in addition to college expenses.
- You can manage the investments yourself and may have more investment flexibility than with a 529 plan.
- Only $2,000 a year can be contributed.
- Individuals earning more than $110,000 ($220,000 if married) do not qualify.
- Withdrawals are subject to income tax and a 10% Penalty if not used for qualified educational expenses (much like 529 plans).
These plans can be good for families who are hoping to use the money for qualified K-12 expenses. If the money is intended to be used only for college expenses, the same considerations for what happens if the child chooses not to pursue higher education need to be considered. The contribution and income limits make this investment vehicle more restrictive for college savings.
UGMA and UTMA Accounts
While not strictly college investment vehicles, until relatively recently UGMA and UTMA accounts were the only tax-advantaged way to set aside money for a child's education. UGMA and UTMA accounts are a way to transfer money to a minor using the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA).
Because children under 18 cannot be custodians of investments, UGMA and UTMA accounts were created to allow children to own securities while an adult maintains control of them until the child reaches the appointed age, called the age of majority (21 in Michigan), at which point the child gains full access and control of the money.
If the child is 18 years or older when money is withdrawn from the account, the earnings are taxed at the child's income tax rate rather than the parents'. This can be an advantage because the child is likely to be in a lower tax bracket than the parents.
- There is no penalty if the money is not used for qualified education expenses.
- There is a wide variety of investment options and flexibility.
- Money in an UGMA/UTMA account is considered the child's, which has a greater impact on financial aid qualification than money in the parents' name.
- Once the child reaches the age of majority (21 in Michigan), the money is theirs, regardless of their capacity to spend it wisely.
UGMA or UTMA accounts can be appealing to people who are concerned about what happens if their child doesn't go to college. However, parents need to understand that the money belongs to the child, and they will be able to spend it however they wish once they are of age. If your kid chooses to take the money and spend it on a motorcycle and cigarettes, there will be little you can do. Surely your child will never be irresponsible with money, but there are other college-age kids that might not actually benefit from a large, unrestricted sum of money they did not earn.
Saving for college can be a daunting task for many families. As with any investment, there is an advantage to starting early, and choosing the right college savings option for your family is an important part of reaching your goal. Talk with an advisor today to decide which option is right for you and learn how to get started.