The Best Ways to Save for College
By Kelly Kearsley
With tuition increasing an average of 8 percent a year, it seems clear that the cost of college will continue increasing even faster than inflation and average income growth for the foreseeable future. What's less clear is how families should go about putting aside funds to pay for their children's (or grandchildren's) education. Both 529 saving plans and traditional custodial trusts are popular college savings tools. Education Savings Accounts, also known as Coverdell Savings Accounts, are less well known, but have their own advantages. Deciding which one works best for you depends on several factors, including how you plan to spend the funds and who you want to control them.
"The best thing is to look at all the options and understand the tax benefits of all of them," said Chris Haeck, sales director for CollegeInvest, a division of the Colorado Department of Higher Education. Then get started. "With college costs rising at double the inflation rate, the longer someone puts off saving, the more they will have to save."
529 Savings Plans. Named after the section of the Internal Revenue Code that created them, 529 savings plans are college savings plans run by states or educational institutions. (Each state sponsors at least one.) They function a lot like your 401(k), except you're saving for college instead of retirement. Their primary benefits are that they're:
- You establish an account for the plan's beneficiary namely, the aspiring college student. You choose investment options, ranging from mutual funds to money market accounts. Then, the plan invests your contributions.
- The account owner not the future student maintains control of the money and account withdrawals.
- Withdrawals must pay for qualified higher education expenses. Four-year universities come to mind first, but the plans can fund vocational school and even less traditional, post-secondary training. Haeck recalled one 529 account beneficiary who used his money for training to become a professional golfer.
- Contributions to a 529 plan are made after taxes, but earnings grow tax-free as long as you use the money for qualified education expenses.
- Depending on where you live, you may also be able to deduct contributions to your 529 plan from your state income tax.
- No matter where in the U.S. you live, account owners can use funds from any state plan to cover qualified educational expenses. This lets you shop around for a well-managed plan with low fees. "The portability of the plans allows people to choose the one that they want," Haeck said.
- The savings plans differ from prepaid tuition plans, which also fall under section 529 of the IRS code. Prepaid savings plans let you purchase college credits for public universities in your state at the current tuition rate. Those credits can be used years in the future, when tuition costs may be much higher.
- Families can change the plan's beneficiary at any time, and you can transfer unused balances to another child or family member. Those features can help you avoid a 10 percent penalty and a tax on any earnings if the funds are withdrawn and not used for educational expenses.
Education Savings Accounts. Similar to 529s, ESAs allow you to build tax-free savings for education. The money can be used for primary and secondary schools as well as college. But unlike 529s, ESAs allow only individuals earning less than $110,000 per year, or $220,000 for joint filers, to contribute to the account. However, the income requirement doesn't apply to organizations, so trusts and corporations could also contribute to an ESA. The money must be spent by the time the beneficiary is 30 or transferred to a younger family member. Contribution rates are lower as well.
Although there are numerous restrictions on these types of accounts, the flexibility they afford for paying for elementary school or high school mean they can be a useful tool in your education funding arsenal.
Custodial Trusts. The federal Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA) creates a simple way for minors to own investments something prohibited by most states. UGMA/UTMA accounts aren't designed specifically for college saving, but they are often used to do just that. Their critical features are that they're:
- You start by appointing a custodian and designating the minor who will benefit from the account. As the donor, the money you put in the trust is irrevocable, meaning you can't take it back.
- The accounts are usually created at banks or brokerages, so you can invest the money where you want. "You have more investment options compared to a 529," Haeck said. Trusts can include individual stocks, mutual funds, real estate even fine art.
- Funds in the trust belong to the minor, but the custodian controls them until the minor reaches a specific age often between 18 and 21, depending on the state and the type of the account.
- UTMA/UGMA accounts are subject to federal income taxes, and contributions are not deductible from your state income tax.
- The account's earnings and gains are taxed when its assets record earnings. While the first $950 of unearned income is tax free, unearned income above $1,900 is taxed at the parent's rate.
- Your contribution is irrevocably gifted to the minor, so you cannot change beneficiaries. And control over the account moves to the beneficiary when he or she reaches 18 or 21, depending on the type of the account and where the trust is located.
- UTMA/UGMA accounts don't restrict how the money is spent, only that the funds be used for the benefit of the minor.
- Though the two trusts are similar, UTMA accounts are slightly more flexible with the type of investments allowed. The minor can own different types of property including real estate, patents and royalties.
Regardless of which savings track you choose, starting early ensures that you have meaningful resources allocated to your children or grandchildren's education no matter how much it costs. It's a lesson in wise planning they won't ever forge.
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