Two very close friends of mine had their first child last week — a healthy and quite adorable baby girl! I met her for the first time at the hospital, and just 17 hours after she was born Mom and dad were already talking about planning for baby’s education. Never too early to start pressuring them about going to college, right?
The three most common vehicles utilized to save money for a child’s education are the 529 plan, the Coverdell, and the UTMA. Each of them have positives and negatives, so it can be a challenge for some to choose the right one for their situation.
Universal Transfers to Minors Act (UTMA)
An UTMA account is a mechanism for gifts to be made to a minor child and held by a custodian until that child reaches a certain age (21 in most states). Contributions satisfy the IRS’s requirements for up to a $14,000 exclusion per year from the gift tax. UTMAs are subject to the kiddie tax, which limits the tax advantages of the account. The first $2,000 in interest, dividends, and capital gains are taxed at the child’s rate and children get a $1,000 standard deduction they can use to make the first $1,000 in investment income tax free. Everything above that is taxed at the parent’s rate, though, and with the cost of college what it is your account is going to need to be much larger than one that’s only spinning off $2,000 a year in investment income.
Also, the UTMA isn’t restricted to educational needs. It is an irrevocable asset that belongs to the child and they are free to do with it what they please once they reach the state’s age of majority. Some might view this as a positive as there wouldn’t be a penalty for taking the money out for a need of the child other than educational. But giving a 21 year-old free reign over a large sum of money rarely ends well. What if Junior turns out to be a big Sons of Anarchy fan and would rather join a biker gang than go to college? Whether you like it or not, that money is going to pay for a new Harley. And possibly some meth.
It’s also important to know that UTMAs generally hurt the student’s financial aid eligibility more than Coverdells or 529 plans because colleges view UTMAs as the student’s asset. So if your goal is only to save money for your child’s education, I recommend avoiding the UTMA.
Coverdell Educational Savings Account (ESA)
You can think of the Coverdell as a Roth IRA for education. It allows you to put money away for educational expenses from kindergarten all the way through graduate school. That money is allowed to grow tax free and distributions will be tax free so long as they are for qualified education expenses (the earnings portion of a non-qualified distribution is subject to income taxes and a 10% penalty).
The big downside to Coverdells is just how little you can contribute — only $2,000 per year. With a cap like that even a crappy online degree from the University of Phoenix could be out of your price range. The Coverdell is appealing, though, for those who plan to send their children to private school. Unlike the 529 plan, which we will discuss next, you can use money from the Coverdell to pay for elementary and secondary education expenses. And let’s face it, in some cities sending your kid to private school could mean the difference between them going to a good college or getting shanked on the playground over a chocolate milk dispute.
529 Savings Plan
The 529 is a state-sponsored plan to help parents save money for their child’s college education. Like the UTMA, the 529 plan allows you to contribute $14,000 per year free of the gift tax ($28,000 for a married couple). The total account size can become quite substantial, as most states allow contributions until the total balance reaches a figure somewhere north of $300,000. Unlike the UTMA, the 529 is an asset of the parents and the child is just the beneficiary. You are free to take the money back or transfer the plan tax-free to another beneficiary in your family, and the IRS is pretty broad on who counts as a family member:
- Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them
- Brother, sister, stepbrother, or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother or sister
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- The spouse of any individual listed above
- First cousin
Like the Coverdell, the 529’s investment returns accumulate tax free. Money from the 529 can be withdrawn tax free for educational purposes including tuition, books, supplies, and room & board (including grad school, trade schools, or special needs schools). If the money is not needed for education and you don’t want to transfer it to another beneficiary it can be withdrawn and will then be subject to a 10% penalty and taxes on the profits only. So it you contribute $100,000 and it grows to $175,000, and let’s say Junior gets a full-ride scholarship, you can take the $175,000 out for yourself but only be subject to taxes and penalties on $75,000 of it.
Contributions are not tax-deductible at the federal level, but most states offer a tax deduction on contributions made to the state’s plan. If your state doesn’t, or their plan simply isn’t good either because of bad investment choices or high fees (looking at you, South Dakota), talk to your fiduciary investment advisor about out-of-state options (Vanguard has a great plan based in Nevada).
When it comes to paying for college, the 529 plan is simply the best financial gift you can give your child. If only knowing how much money you’ll need to put in it were so easy.
