Saving for a child’s education is a very personal decision. I have come across people that want to pay for everything for their children’s education, people who are not going to pay anything, and everywhere in between. The right answer on what to do is, “Whatever you decide.” I would like to share with you a few different ways to save for your child’s education if that is your plan.
The simplest way to save is to set aside some money every month, and invest it into some type of a voluntary account that has your name on it. By not “earmarking” it for education, you are able to do with that money as you would like. Many people will start saving for a child’s education right after they are born. Let’s face it, you don’t really know what a child is going to be like 18 years down the road. Will they even want to go to school? Is there something that will prevent them from being able to attend college? Will they get a full scholarship, or will someone else pay for it? You just never know, and in the case of an “education account” where the money is not specifically set aside for school, you can always do what you wish with that money without the penalties that are associated with college funds that are not used for that purpose.
A second way to save for education is to set up an Uniform Gift to Minors Act (UGMA) or an Uniform Transfer to Minors Act (UTMA) account. These accounts have been available for a long time, but since the rise of the Coverdell Education Savings Account, and the 529 Plans, they have become less common. These accounts are called custodial accounts which means that a responsible party (typically a parent) is named as the custodian of the account. Like the voluntary account above, the money does not have to be “earmarked” for education. The account is meant to protect the assets of the minors until they reach the age of majority, and any withdrawals from the account must be done for the benefit of the child. The age of majority varies anywhere from 18-21 depending on the state you live in. In NY, the age of majority is 21. At that point in time, the assets in the account are transferred into the child’s name, and the custodian is removed from the account. As you will quickly figure out, the child is now in control of the money, and can do with it as he/she pleases. You may have set aside the money for school, but if they don’t want to use it for that purpose, there is no longer anything you can do about it. With the passing of the Tax Cuts and Jobs Act (TCJA) in 2018, the taxation of these accounts was changed. Now, the interest and short term capital gains are taxed as ordinary income, and after the passing of the TCJA, ordinary income is now based on the tax rates for trusts. Those rates are as follows:
The long-term capital gains, and qualified dividends are now taxed at the following rates:
When it comes time to determine financial aid eligibility, about 20-25% of the assets in these accounts are expected to be used towards funding an education in any given year. They are considered assets of the beneficiary as opposed to assets of the custodian.
A third way to save for education is a Coverdell Education Savings Account (ESA). Like the UGMA/UTMA, these are custodial accounts set up for the benefit of a child. However, the money in the Coverdell ESA is set aside specifically to pay for qualified education expenses. These expenses don’t only have to be for college. They can be for any elementary, secondary, or university level school – and those schools can be public, private, or religious. The real benefit of these accounts is with taxation. The money in the account grows tax free, and if withdrawals are made for approved costs relative to your education (tuition, books, supplies, etc.) the withdrawals are also tax free. Additionally, if you don’t use all the money in the account by the time the child reaches 30 years old, you can transfer the money to another beneficiary and maintain those tax advantages. The limitation of the Coverdell is contributions. The most you can save in a Coverdell is $2,000/year, and you cannot contribute to the account after the child reaches 18. As it stands today, you may not contribute to a Coverdell at all if your AGI is over $110,000 for a single filer, and over $220,000 for a joint filer. If for some reason a distribution from a Coverdell exceeds the qualified education expenses for a year, the excess will be taxable, and there will likely be a 10% penalty on top of that. Unlike the UGMA/UTMA accounts, these accounts are considered assets of the custodian, and not assets of the beneficiary. That means that currently around 5.6% of the assets are factored into federal financial aid formulas.
The fourth, and perhaps most widely utilized, way to save for college is the 529 plan. These plans are sponsored by states, state agencies, or educational institutions. They are authorized by Section 529 of the Internal Revenue Code. Almost all states have their own 529 plan (currently, the only exception is Wyoming), and you don’t need to invest in your state’s 529 plan if you don’t want to – you can invest in any one of them. However, there may be some advantages to investing in your home state’s plan. For example, if you live in NY, and invest in one of the two 529 plans offered here, you can deduct your plan contributions up to $5,000 per year for an individual and $10,000 per year for a couple from your NY taxable income. The 529 plan has some similarities and differences to the Coverdell ESA. Like the Coverdell, the money invested into the 529 plan grows tax-free, and if the distributions are made for qualified education expenses, they are also tax-free. You can also change the beneficiary of a 529 account if you want to, and the account owner maintains control over the distribution of assets. If you withdraw more that you need for a year, you are subject to taxes on the difference and a 10% penalty. Finally, around 5.6% of the assets of the 529 are factored into federal financial aid formulas. With the passing of the Tax Cuts and Jobs Act (TCJA), families can now take federally tax-free withdrawals to pay for up to $10,000 of K-12 tuition. However, as it currently stands, NY has not conformed to this new tax code, so the withdrawals may not qualify for state tax benefits. If you withdraw funds from a 529, you may be subject to state income tax, and in some cases a penalty, on the earnings. You may also have to repay any deductions, or credits claimed. As these rules are changing all the time, you should check with the state to find out how withdrawals for K-12 tuition are handled. There are also no income limits imposed on the account holder, so anyone can contribute to them. The age limit is lifted as well. Additionally, anyone can be a beneficiary of a 529 plan. If you decide you want to back to school when you are in your 40’s, you can use a 529 plan to help you pay for it. Perhaps the biggest difference relates to the amount of the contributions you can make. You can contribute up to $75,000 in a single year per beneficiary, or $150,000 per married couple, splitting the gifts to two beneficiaries, as an annual gift-tax-free transfer (the limit for the Coverdell was $2,000/year). If you do that, though, you cannot contribute any more to the same beneficiary for the next 5 years without triggering the federal gift tax. You must also prorate the contribution over the next 5 years. You can’t count the entire amount in one year towards your taxes.
As you can see, there are a number of different ways to set money aside for a child’s education. Remember that the rules on contributions, and taxation change all the time, so do your due diligence by researching the type of account that works best for you, and talk to a professional to make sure you are not missing anything.
Investments in 529 plans involve risks to principal and may involve additional fees such as enrollment charges and annual maintenance fees. 529 plans offer no guarantees. Depending on your state of residence and the state of residence of the beneficiary, the plan may or may not be eligible for state tax benefits. There are exceptions to the gift tax and estate tax exemptions; please contact a qualified tax, legal or financial advisor for more information prior to investing.
Securities America and its representatives do not provide tax advice; therefore it is important to coordinate with your tax advisor regarding your specific situation.
Securities offered through Securities America, Inc., a Registered Broker/Dealer, Member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc., an SEC Registered Investment Advisory Firm. The Securities America Companies and Emerald Financial Services are separate entities.
Written by Joel R. Maness