Saving For College

It’s never too early to start thinking about saving for your child’s education. When Little Random Guy arrives in about one month, he’ll be happy to know that we have already started saving for his college education. With the average student loan debt of a college graduate at $37,172, our hope is to have enough saved to minimize this type of debt burden. Much like retirement, saving for your child’s education takes some planning. And with tuition rising at a rate higher than general inflation, it’s important to know what options are available to help you save and grow your money. The first two options I’ll talk about, the 529 Plan and the Coverdell ESA, are specifically for education expenses. The third option, a UGMA/UTMA account, is a way to save for minors but has no tax benefits if used for education expenses. Each of these plans have their own particulars when it comes to setting up the account, making contributions, tax advantages, and taking distributions. Savingforcollege.com actually has a lot of great information about… well, saving for college. I encourage you guys to go check out that site.

 

529 Plans

These are savings plans used to set aside funds for college and any other post-secondary training. There are actually two different kinds of 529 plans. One type is a savings plan, which is similar to a 401k or an IRA. You make contributions, the contributions accrue earnings over time, and the funds in the account can be used for qualified education expenses at any accredited college or university. You can name anyone as a beneficiary, including yourself, and there are no age limits for the account as well. Also, state plans are okay to use for out-of-state colleges. For example, if you open a California 529 plan, you can use it for college in any other state without penalty. The second type of 529 plan is a prepaid plan in which you prepay for all or part of the costs of a public institution. There are also Private College 529 plans in which you can prepay for certain private colleges.

Making Contributions

There are no income limits in terms of making contributions. There are also no annual contribution limits, although they are treated as a gift to the named beneficiary. Your maximum aggregate amount (contributions plus earnings), however, are limited and cannot exceed the amount needed to provide for the qualified education expenses of the beneficiary. The exact amount varies from state to state as well as plan to plan. Once the total holdings reach this limit, you can no longer make contributions. However, your account can still accrue earnings beyond the plan limit.

Tax Benefits and Distributions

Some states offer tax incentives such as state income tax deductions, however contributions are non-deductible in terms of federal income taxes. Earnings grow tax-free and are not taxed when used for qualified education expenses. Earnings for non-qualified expenses will incur income tax and an additional 10% penalty. Also, there are no “forced distribution” criteria such as reaching a certain age or graduating from college. Unused assets remain in the account and can continue to generate earnings.

Making Changes

You can change investment options twice per calendar year. You can rollover funds into another 529 plan one time in a 12-month period. You can also change the beneficiary to a qualified family member without tax consequences. However, there can be tax implications if you skip a generation or if the change is to a beneficiary that is not a qualified family member.

Impact on Financial Aid

Funds in a 529 plan owned by a dependent student or one of their parents are considered parental assets. Parental assets have less impact on financial aid than student assets.

 

Coverdell ESA

A Coverdell ESA (Education Savings Account) is a type of custodial account that allows you to save for future qualified educational expenses. Being a custodial account, the custodian (usually you) must administer the account for the benefit of the designated beneficiary. Unlike 529 plans, ESAs cover elementary and secondary education expenses as well as higher education. When the account is started, the designated beneficiary must be under the age of 18 or a special needs beneficiary.

Making Contributions

You can make non-deductible contributions if your modified adjusted gross income (MAGI) is less than $110,000 ($220,000 if filing a joint return). The annual total contribution limit is $2,000 with a MAGI of less than $95,000 ($190,000 for joint filers). This limit gradually phases out as your MAGI falls between $95,000 and $110,000 (or $190,000 and $220,000 for joint filers). If your income falls above the MAGI limits, you can gift the contribution to your child/beneficiary first and then have them contribute it to the account.

Tax Benefits and Distributions

Contributions are non-deductible. However, they grow tax-free in the account until distribution. Distributions can be taken at any time. On distribution, the earnings are tax-free if used for qualified education expenses. If not, earnings are subject to income tax as well as a 10% penalty. Also, the account must be distributed within 30 days if the beneficiary reaches 30 years of age (unless the beneficiary is a special needs beneficiary) or upon the beneficiary’s death.

Making Changes

You can change the beneficiary so long as they are under the age of 30 (or a special needs beneficiary) and are a qualifying family member. You can also move funds from an ESA to a 529 for the same beneficiary in the same taxable year.

Impact on Financial Aid

Holdings in an ESA are considered assets of the custodian and not of the child/student and therefore have less impact on financial aid.

 

UGMA/UTMA Custodial Accounts

UGMA (Uniform Gift To Minors Act) and UTMA (Uniform Transfer to Minors Act) accounts are types of custodial accounts set up by an adult on behalf of a minor. The custodian of the account controls and manages the assets for the minor. A parent does not have to be the custodian of the account. Any money or assets contributed to the account are “irrevocable gifts” to the trust and ultimately belong to the minor. Once the child reaches the age of maturity, the account transfers to them and they can use the assets for any purpose.

Making Contributions

There are no income limits when making contributions, and there are no limitations on contributions.

Tax Benefits and Distributions

Income from the custodial account is taxed at the child’s rate, which is usually lower than that of the parent. Contributions are not tax-deductible. Earnings can be subject to the Kiddie Tax rules. For 2016, the first $1,050 of unearned income will be untaxed. The next $1,050 is taxed at the child’s tax rate, and unearned income in excess of $2,100 will be taxed at the parent’s rate. Distributions can be taken at any time but must be used for the benefit of the child.

Making Changes

You cannot change the beneficiary of a UGMA/UTMA account. You can transfer assets from a UGMA/UTMA account into a 529 plan. These accounts are known as Custodial 529 plans. The beneficiary, however, cannot be changed and must remain the same. Also, the child remains the owner of the account and will gain control of the assets upon reaching the age of maturity.

Impact on Financial Aid

Holdings are considered assets of the child when it comes to calculating financial aid. This will have more of an impact on obtaining financial aid.

 

Random Guy’s Thoughts

In my opinion, I would use a 529 savings plan to save for my child’s college education. In fact, I’ve already started contributing to one for Little Random Guy. I just find certain aspects of 529 plans appealing, such as tax-free growth, no income limits for making contributions, no limits on annual contributions, no age restrictions, and the flexibility of changing beneficiaries. And although I like that Coverdell accounts can be used for primary and secondary school expenses, I find the rather low annual contribution limit and the age restrictions a bit too limiting. I would avoid using UGMA/UTMA accounts to save specifically for educational expenses. There are little tax benefits, and once the beneficiary gains control of the accounts, they can use the assets for whatever they want (i.e. on a new, shiny car rather than a college education).

Hopefully this information proves helpful in your quest to save for your child’s education. I will probably write about my Little Guy savings plan at some point in a future post. Until then, thanks for reading!

4 thoughts on “Saving For College

  • November 1, 2016 at 11:58 pm
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    A few years ago, I actually went ahead and opened up a 529 plan under the NY plan (my state has no tax deduction for contributing to a 529). The NY plan has Vanguard total market funds and charges 16 basis points (0.16%). And it only requires a $25 minimum deposit. Since I like to tinker, I figured I could spare 25 bucks a month to try to learn how a 529 plan works. Call it the cost of doing business.

    Of course, on hiccup…I have no children! So I just opened up an account in my own name and figure I’ll move it to some future child’s name at some point. And if I don’t have kids for some reason, well, then I’ll just save what I’ve got in there and use it when I’m old to take some classes.

    I think it’s not a bad idea to just open up a 529 plan and see how it works, even if you don’t have kids. I think all of us can spare 25 bucks to try to learn how important financial stuff works.

    • November 2, 2016 at 4:38 am
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      Smart move! I opened mine a few months ago. I like the fact that you can start an account even before your kid is born, then change the beneficiary at some later time. It can give you a head start on the saving. And, like you said, if you end up not having a kid you can always use it for yourself. My state doesn’t offer deductions as well, so I just opened one at Vanguard since I have a few other accounts with them already. Thanks for the comment!

  • November 2, 2016 at 12:15 am
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    We use a 529 to fund junior’s future college expenses. We are lucky that the state of Virginia allows up to $4k a year to be deducted from our state tax return. So we contribute $4k each year and hopefully by the time he’s 18, he’ll have enough for college.

    • November 2, 2016 at 4:55 am
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      Awesome! $4k a year is a nice amount to deduct from your state taxes. My state (California) doesn’t offer deductions so I went with Vanguard’s 529 plan. I’m sure junior will be thankful for whatever you have saved for him. As for our Little Guy, whatever we have save for him will be that much more than what I had for college! Thanks for the comment!

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