//Which college savings account should I use?

Which college savings account should I use?

Just like your choice for retirement, you have to answer two questions when deciding where to invest for college:

  1. What type of vehicle do I use to invest for college?
  2. What do I actually invest in within that vehicle?

The good news is you don’t have nearly as many choices when deciding where to invest for college.

The bad news is that the accounts differ in many ways, including tax benefits, contribution limits, which expenses are eligible, ability to change beneficiaries, income limits, financial aid treatment, investment options, and more.

There are 3 main types of accounts parents (and grandparents) choose for children:

  1. 529 Plan
  2. Coverdell ESA (Education Savings Account)
  3. UGMA/UTMA (Uniform Gift to Minors Act / Uniform Transfer to Minors Act)

I’ve put together a comparison chart listing the most relevant features of these three main options you have for college savings:

Click here to download this table as a handy PDF!

YEAR 2016 RULES 529 Plan Coverdell ESA UGMA/UTMA
Federal Income Tax on Contributions Non-deductible contributions Non-deductible contributions Non-deductible contributions
Federal Income Tax on Earnings Earnings are tax-deferred until withdrawn and tax-free to the extent of qualified higher education expenses Earnings are tax-deferred until withdrawn and tax-free to the extent of qualified higher education expenses. Withdraws for qualified K-12 expenses also tax-free Earnings and gains taxed to minor each year; first $1,050 of unearned income is tax exempt; unearned income over $2,100 for children through age 24 is taxed at parents rate
State Income Tax on Contributions Each state is different but many offer a tax deduction on contributions up to a limit Non-deductible contributions Non-deductible contributions
Federal Gift Tax Treatment Contributions treated as completed gifts. $14,000 annual exclusion or up to $70,000 with 5-year election Contributions treated as completed gifts. $14,000 annual exclusion Transfers treated as completed gift. $14,000 annual gift exclusion
Federal Estate Tax Treatment Value removed from donor’s gross estate; partial inclusion for death during a 5-year election period Value removed from donor’s gross estate Value removed from donor’s gross estate unless donor remains as custodian
Maximum Investment Established by the program; many in excess of $300,000 per beneficiary $2,000 per beneficiary per year combined from all sources No limit
Qualified Expenses Tuition, fees, books, computers and related equipment, supplies, special needs. Room and board for students attending at least half-time Tuition, fees, books, supplies, equipment, special needs. Room and board for students attending at least half-time. Additional categories of K-12 expenses No restrictions
Able to Change Beneficiary Yes, to another member of the beneficiary’s family Yes, to another member of the beneficiary’s family No, represents an irrevocable gift to the child
Time/Age Restrictions None unless imposed by the program Contributions before beneficiary reaches age 18. Use of account by age 30 Custodianship terminates when minor reaches age established under state law (generally 18 or 21)
Income Restrictions None Ability to contribute phases out for incomes between $190,000 and $220,000 (joint filers) or $95,000 and $110,000 (single) None
Federal Financial Aid Counted as asset of parent if owner is parent or dependent student Counted as asset of parent if owner is parent or dependent student Counted as student’s asset
Investments Limited to investment strategies as developed by the program Broad range of securities Broad range of securities as permitted under state laws
Use for Qualifying Expenses Higher education. Any accredited trade or vocational school, college, or graduate school in the United States or abroad K-12 and Higher education. Any accredited trade or vocational school, college, or graduate school in the United States or abroad Funds must be used for benefit of the minor
Use for Nonqualifying Expenses Withdrawn earnings subject to federal tax and 10% penalty Withdrawn earnings subject to federal tax and 10% penalty Funds must be used for benefit of the minor

Click here to download this table as a handy PDF!

Hopefully the comparison chart answers most of your questions, but in case you got lost, let’s explore some of the more important features that may help with your decision:

Contribution limits and restrictions

One major drawback for many families is the $2,000 limit per child restriction imposed by the Coverdell ESA.  529 Plans typically allow you to contribute $300,000 or more and the UGMA/UTMA has no contribution limit.

Another potential drawback of the Coverdell ESA is that you may not be able to contribute if your income is too high ($95-110k limit for single tax filers and $190-220k limit for joint filers).  However, there is a workaround where you gift money to your child and then he or she contributes to the Coverdell ESA.  529 Plans and UGMA/UTMA have no income limits.

These limits alone may make your decision or at least eliminate one option.

Income tax treatment

The tax treatment starts to get a little complicated.

The main tax benefit and reason parents choose college-savings accounts is the ability for tax-free growth with the 529 and Coverdell ESA plans.  They work the same as Roth IRAs as long as you withdraw money for qualified higher education purposes – tuition, fees, books, computers, supplies, room and board (for students attending at least half-time).

The lesser known UGMA/UTMA doesn’t offer tax-free growth, but the first $1,050 of unearned income (interest, dividends, capital gains) is tax exempt each year.  So you can get quite a bit of tax-free growth in these accounts with more flexibility on the uses of the money.

State Income Tax Deduction

The 529 is unique in that it offers a state income tax deduction on the contributions you make.  Each state is different, but you can find a breakdown here.

Some parents subject to high state income tax rates make their decision on this benefit alone.

What if the money isn’t used for college?

This is the big “catch” for the 529 and Coverdell ESA plans.  If you don’t use the funds for qualified higher education expenses, then you pay a 10% penalty and ordinary income taxes on the earnings in the account.

One good piece of news, though.  You may withdraw money without the penalty and taxes for scholarships earned.

However, if your child doesn’t go to college, then you’ll have to bite the bullet and pay Uncle Sam.

I think most of us assume our children will go to college, though so this may not be much of an issue.  If it is, you may opt for the flexibility of the UGMA/UTMA and forego potential tax savings.

Wrapping Up

The college-savings decision is fairly complicated and depends on many variables.  I’m afraid there isn’t a one-size-fits-all solution.  Hopefully, the comparison chart and discussion here help you with your decision.  Don’t hesitate to reach out for a quick 15-minute call if I can help!

2016-10-18T13:32:56-04:00

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