The cost of college is steadily rising, and student loan debt has reached crisis status. What does this mean for you? It is more important than ever to commit to saving for the education expenses of the future scholars in your life.
But making that commitment to save is just the first step. Next, you must decide on the right savings plan — a 529 plan, a Coverdell Education Savings Account or a custodial account — a decision that should not be made lightly. These account types differ in ways big and small, and choosing the best option for your situation requires a careful analysis of each.
The 529 Plan
The 529 plan gets its name from section 529 of the Internal Revenue Code (IRC). This plan is operated by a state or educational institution and is designed to help families set aside funds for future college expenses. To be clear, the 529 account is for college expenses only, and it cannot be used for elementary or secondary tuition and expenses.
Anyone can establish a 529 plan for the benefit of whomever they choose, as there are no income, age or annual contribution limits. If you invest in your state’s sponsored 529 plan, you may be eligible for a state tax deduction or credit for 529 plan contributions. As the donor of a 529 plan, you remain in control of the account and can ensure that the money will be used for its intended purpose. You also retain the right to withdraw funds from the plan at any time, for any reason, and to change the beneficiary.
Earnings in a 529 plan grow federal tax-free and will never be taxed as long as the money withdrawn is used for “qualified” higher education expenses, which includes tuition, room and board, fees, books and equipment. Distributions not used for qualified higher education expenses are allowed, but are subject to federal income tax, plus a 10% penalty. Taxes and penalties apply only to earnings in the account.
In addition, 529 plans can be a valuable gift and estate tax planning tool, as contributions are considered completed gifts; therefore, they are not included in the donor’s estate, despite the fact that the account owner retains control of the funds. Individuals can make gift tax-free contributions of up to $14,000 per beneficiary, per year (or $28,000 for married couples who elect to gift split). They also have the option to “front load” the plan, consolidating five years’ worth of gifts into a single $70,000 contribution (or $140,000 for married couples) per beneficiary.
What’s the bottom line? The 529 plan has a low impact on Free Application for Federal Student Aid (FAFSA) financial aid, as the account balance is treated as an asset of the account owner, not of the beneficiary.
A Coverdell Education Savings Account functions in a very similar manner to a 529 plan, with a few key differences. Like a 529 plan, the donor of a Coverdell remains in control of the account and can withdraw funds or change the beneficiary to another family member as s/he sees fit. As a result, the Coverdell account has a low impact on financial aid.
The assets in a Coverdell grow tax-deferred, and the distributions are tax-free when used for qualified education expenses. Unlike a 529 plan, however, eligibility to contribute to a Coverdell is phased out for incomes between $95,000 and $110,000 for single filers and between $190,000 and $220,000 for joint filers. In addition, the maximum contribution to a Coverdell is $2,000 per beneficiary per year, and can be made only until the beneficiary is 18. This provision makes it difficult to save considerable sums of money and eliminates most of the gift and estate tax planning benefits of the 529 plan.
Another key difference between the Coverdell and the 529 is that any unused funds must be distributed to the beneficiary at age 30, with earnings taxed as ordinary income plus a 10% penalty. (Keep in mind that 529 plans have no such rules regarding the distribution of unused funds.)
One potential benefit of a Coverdell is that it can be used for elementary and secondary school expenses in addition to college costs, while a 529 plan is restricted to college use.
A custodial account, also known as a Uniform Transfers to Minors Act (UTMA) or a Uniform Gifts to Minors Act (UGMA) account, differs from both 529 plans and Coverdell accounts in several important ways. First and foremost, assets placed into a custodial account are an irrevocable gift to the beneficiary and are immediately placed in the name (and under the tax identification number) of the child. The parent (or other designated guardian) who established the account serves as the custodian, with a fiduciary responsibility to the beneficiary to ensure that the assets are used for his or her benefit only.
Once the child reaches the age of trust termination — which varies by state, but is typically between 18 and 21 years — the child gains complete access and control of the assets and can use them for whatever s/he wishes. All income earned in a custodial account is taxable to the child at his or her tax rate.
For 2017, the first $1,050 of unearned income was tax-free, the next $1,050 was taxable to the child, and anything more than $2,100 was taxed at the parents’ or designated guardian’s top marginal rate. Because the asset is in the child’s name, it counts as a student-owned asset for financial aid, leading to a much larger impact on financial aid than a 529 plan or a Coverdell Education Savings Account. Like a Coverdell, however, the money can be used for elementary and secondary school expenses, in addition to college.
What’s Your Goal?
Each of these college savings instruments can help you lessen the burden of future education expenses. Just be sure to pay close attention to the advantages and drawbacks of each to ensure that whatever plan you choose aligns with your education savings goals.
Gary S. Williams is president and founder of Williams Asset Management in Columbia. He can be reached at 410-740-0220 or at [email protected]