College Savings

Posted on: August 27, 2013 by Martin Curiel, CFA in Wealth Management

Many parents today are concerned about the rapidly increasing cost of college. Although no one can predict what the exact cost of a university degree will be in 18 years, proper planning is essential. There are several types of accounts used to build up college funds with varying degrees of costs, flexibility, and tax savings. Most of these solutions do not provide an immediate tax deduction during contribution, but some do provide tax-free earnings. Those with tax-free earnings are similar to a Roth IRA, which has post-tax contributions and tax-free earnings. In this article, we will touch briefly on the types of accounts available.

While there are numerous options for saving for a child’s education, the four primary types of college savings accounts that we discuss with our clients are the following:

1. Savings Accounts
2. 529 Plans
3. Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) Accounts
4. Coverdell Educational Savings Accounts (ESA)

We will begin the discussion by defining each account type and citing some of the advantages and disadvantages of each.

Savings Accounts

Using a savings account is certainly one of the most common strategies to cover the cost of education that we see with our clients. Parents and/or grandparents realize that Junior’s tuition bill is due next month, and so they quickly dip into their savings account to fulfill the obligation. If they are a little proactive, a separate savings account exists for college expenses – but most simply raid their existing accounts. The advantage of this strategy is its simplicity – not much extra work is needed, and there is no need for managing multiple accounts. Funders also have full flexibility in investment options and use of funds. The disadvantage primarily stems from the fact that it’s tax inefficient. A regular savings or checking account will generate interest income, which is classified as ordinary income, and thus taxed at the highest marginal tax rate. Another disadvantage is that savings accounts typically yield very low returns; in today’s interest-rate environment, they are not even keeping pace with inflation.

529 Plans

These plans have gained much in popularity over the last several years. Anyone can contribute to a 529 plan, including parents, grandparents, or other relatives. The advantages include the fact that earnings are tax-free when used for eligible educational expenses; contributions, however, are not tax deductible on the federal return or most state returns. Although it is rare, some states do provide a tax deduction for contributions. Disadvantages of a 529 include the limited number of investment options – the investor is pretty much stuck with a limited set of mutual funds or other vehicles available for that particular plan. Also, 529s typically impose management fees above and beyond those imposed by the mutual funds and money managers involved in managing the investments. The fact that only cash (not appreciated stock) can be used to fund the account can also be tax inefficient.

UTMA/UGMA Accounts

Somewhat more complicated than the others discussed here, UTMA/UGMA accounts are a type of trust account that can round out the mix of available options. One advantage is that parents are able to contribute appreciated stock to the account, which creates a tax savings opportunity. Funds in UTMA and UGMA accounts can also be transferred to a Coverdell ESA; this is advantageous when the parents’ income is too high to qualify for funding a Coverdell ESA. Another key advantage is that the funds inside one of these accounts can be used beyond tuition and school fees; as long as the money is being used “for the benefit of the child,” then it can be used broadly (e.g., for child care expenses, purchase of a vehicle for the child, trips to visit universities, etc.). Disadvantages include the fact that funds cannot be transferred to another beneficiary and the fact that relatively more paperwork is required – a tax return is often mandatory for the child at the end of each year. Unlike with a 529, capital appreciation on the investments above the child standard deduction will be taxed. One potential issue for those parents whose children grow up to be less than responsible is the fact that at the age of 21 (or sometimes 18), the child will gain full control of the funds. He or she will be free to use the money to pay for Stanford’s engineering program or spring break festivities in Cancun, Mexico – in either case, the parents will be watching from the sidelines after the child reaches the designated age. One final consideration is that the assets in these vehicles will be treated as student assets in most financial aid calculations, which could reduce need-based financial aid.

Coverdell ESA

The Coverdell ESA is a bit limited in terms of its savings potential, but nevertheless worth mentioning. Like the 529, advantages of an ESA include tax-free earnings when used for eligible expenses. The ESA also has the great advantage of full flexibility in terms of investment options, including low-cost, tax-efficient products. The major disadvantages are that only $2000 per year can be contributed and contributions must be in cash. There is also an income limit for making contributions. Like UTMA/UGMA plans, assets in Coverdell ESAs may be treated as student assets in financial aid calculations, which could reduce need-based financial aid.

Our analysis:

Contributions to 529 plans, UTMA/UGMA accounts, and Coverdell ESAs, together with all other gifts from the account owner to the beneficiary, may qualify for an annual federal gift tax exclusion of $14,000 per donor ($28,000 for married contributors) in 2013.

The best option for fees, taxes, and flexibility is the Coverdell ESA, but it is limited to $2000/year received by each beneficiary. Also, those with high incomes - phase out starts at $95,000 for single filers and $190,000 for married filing jointly - are not allowed to contribute to Coverdell ESAs. However, anyone can contribute to a UTMA/UGMA account, and the child can use those funds to contribute to a Coverdell ESA.

When the parents have stock that has appreciated, sometimes the best option is to transfer it to the child using a UTMA/UGMA account. In 2012, the first $950 of the child’s income was tax-free and the next $950 of income was taxed at the child’s rate. Income beyond that was taxed at the parent’s rate.

The most efficient method of saving for college varies by the individual. Some prefer the simplicity of having fewer accounts, while others prefer the flexibility and lower fees available when holding multiple accounts.

To summarize, the MYeCFO perspective and insight on this topic:

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