Your options for college savings plans
I recently spoke with a couple of neighbors who asked if I would write about college savings. So here is an overview of some options.
Custodial accounts have been around for a long time and are one of the older options available to parents, grandparents and others who desire to help pay for college expenses. The account can be opened by a parent, friend or relative who would be the custodian of the account for the behalf of the minor. These are referred to as Uniform Gift to Minors Act (UGMA) or Uniformed Transfer to Minors Act (UTMA) accounts. No limit on contributions. Withdrawals must be made on the minor’s behalf.
The owner of the assets is the minor and in California the assets must be released to the owner somewhere between the ages of 18 and 25, at which point the young adult may spend the money any way they choose. For this reason, some may want to choose a savings option which allows for more control.
Custodial accounts also have a tax liability on income. For the current tax year 2018 the following applies: from $0 to $1,050 the income is not taxed; from $1,051 to $2,100 the income is taxed at the child’s rate; over $2,100 will be taxed at the custodian’s rate. This continues until 2026 when the individual tax rates in the new tax law expire at which point the amount above $2,100 would be taxed at the same rate as income in a trust.
The investment options are very flexible depending on what type of institution you open the account with. For instance, in a brokerage account you may hold stocks, bonds, mutual funds, ETFs, etc. At a mutual fund company, you would be limited to the family fund of mutual funds offered.
U.S. Series EE and Series I bonds are used for college savings. You should be able to purchase these bonds at your local bank. The face value of the bonds can vary from $50 to $10,000. The bonds offer special tax benefits if used for qualified college expenses and if you meet certain income requirements.
For tax year 2018 a married couple filing jointly must have a modified adjusted gross income (MAGI) of less than $117,251, and for a single tax payer less than $78,151 to get the full tax benefit. MAGI above those numbers will reduce your benefit and is completely phased out at $147,250 for joint filers and $93,150 for single filers.
These bonds are backed by the full faith and credit of the federal government and therefore considered to be a relatively safe investment. A disadvantage is that there is a limit to the amount of bonds that you can buy in one year, a maturity period, and a penalty for early withdrawal.
Coverdell Education Savings Accounts (ESA’s) were known as Education IRA’s prior to 2002. These accounts allow you to save not just for college but, also elementary and secondary schools (K-12), at public, private and religious institutions.
Anyone can contribute up to a maximum of $2,000 per child. The maximum is per child annually. To clarify, two people can contribute $1,000 each to the same child’s account for a total of $2,000 but, not $2,000 each to the same child which be a total of $4,000.
Investments in ESA’s grow tax deferred. Unlike the custodial accounts, you will not be paying taxes annually. Withdrawals from the account will be both federally and state tax free if for qualified expenses. If not, then the earnings of the withdrawal will be taxed at the beneficiary’s tax rate and a 10 percent penalty would be imposed.
Investment options are flexible in the same way as the custodial accounts depending on which type of financial institution you choose to open the account. There are some income limitations as to who can open ESA’s. Taxpayers filing married jointly must have a MAGI of less than $190,000 and for single filers $95,000. Once the beneficiary reaches age 30, then funds must be distributed. The exceptions are in the case of a person with special needs.
529’s offer two different ways to save for college. The 529 Savings Plan option and the 529 Prepaid Tuition option. The 529 savings plan has a lot of flexibility. There are no income limitations as to who can open a 529. Anyone can contribute to someone else’s account so, keep the birthday checks coming!
There is an account owner, usually the parent or grandparent, and a beneficiary whom we hope to help with college expenses. One key difference between the 529 savings account and other options is that the beneficiary may be changed therefore, unlike the ESA which must be distributed by the age of 30, the 529 can be moved on to another potential collegiate. There are some limitations as to who can become the new beneficiary but quite flexible within the familial relationships. You might consider this a legacy fund for the family.
The accounts are normally held at mutual fund companies and investments would be limited to that family of mutual funds. The investments will grow tax deferred. Some states offer additional tax benefits but, California does not. Withdrawals are tax free if they are used for qualified expenses. In this case the expenses can be for room, board, books, and even computers if required for
specific course study. Recent change in the tax law allows for qualified distributions for K through grade 12 but in most cases, it would be better to wait to for the higher expenses that await the college years.
Prepaid tuition is just that. This plan allows you to pay today’s prices now, for college tuition which will be used later. That is quite an advantage considering the high inflation that we are experiencing in higher education.
Rather than buying an investment to sell later and use for college expenses, you are purchasing units or credits which have a pre-determined value. These may be purchased in a lump sum or periodically according to the plans, rules and limitations.
These plans can be run by the college or the state. Staterun plans require you be a resident of that state. Another limitation is that you can only use this for tuition not room, board or other expenses. The limitations make this option inflexible and less attractive to some savers. Although the plan does offer the same tax advantages as the 529 savings plans.
Some people consider using retirement funds for funding education expenses. I would only consider it as a last resort. Retirement is a fundamental goal, funding higher education while admirable is considered a lifestyle goal so families should plan for these future expenses.
All the above plans are made with pre-tax dollars and may have tax consequences so as always, please consult with your team of financial, legal and tax professionals. Consider flexibility, taxation and custodial control when making your decision. Until we talk again, be well!