There are several different approaches to saving for college. We will analyze the benefits and drawbacks of the major ones.
A 529 plan is a tax-advantaged college savings vehicle that lets you save money for college in an individual investment account. In some, you enroll directly. Others require you to go through a financial professional.
Federal tax advantages. Earnings on contributions to your account are completely tax free if the money is used to pay the beneficiary's qualified education expenses. The earnings portion of any withdrawal not used for college expenses is taxed at the recipient's rate and subject to a 10 percent federal penalty.
State tax advantages. Many states offer income tax incentives for state residents (tax deductions for contributions or a tax exemptions for qualified withdrawals, with earnings also tax deferred or tax free). Some states limit their tax deduction to contributions made only to the in-state 529 plan.
High contribution limits. Most college savings plans have lifetime maximum contribution limits.
Unlimited participation. Anyone can open a 529 college savings plan account, regardless of income level.
Flexibility. Under federal rules, you can change the beneficiary of your account to a qualified family member at any time without penalty. You can roll over the money in your 529 plan account to a different 529 plan once per year without income tax or penalty implications.
Wide use of funds. Money in a 529 college savings plan can be used at any college in the United States or abroad that is accredited by the U.S. Department of Education. Depending on the individual plan, funds can also be used for graduate school.
Accelerated gifting. 529 plans offer an excellent estate planning advantage in the form of accelerated gifting. This can be a favorable way for grandparents to contribute to their grandchildren's college educations. The annual limit on contributions for individuals is $13,000 and $26,000 for joint filers. Individuals are able to make a lump-sum gift to a 529 plan of up to $65,000 ($130,000 for married couples) and avoid federal gift tax, provided a special election is made to treat the gift as having been made in equal installments over a five-year period and no other gifts were made to that beneficiary during the five years.
Variety. Currently, there are over fifty different college savings plans to choose from. Many states offer more than one plan, and you can join any of them.
Favorable treatment for federal financial support. Assets are deemed to be owned by the parents.
Prepaid tuition plans are distant cousins to college savings plans: Their federal tax treatment is the same, but just about everything else is different. A prepaid tuition plan is a tax-advantaged college savings vehicle that lets you pay tuition expenses to participating colleges at today's prices for use in the future. Prepaid tuition plans can be run either by states or by colleges. For state-run plans, you prepay tuition at one or more state colleges. For college-run plans, you prepay tuition at the participating college.
Tuition credits. As with 529 college savings plans, you fill out an application and name a beneficiary. But instead of choosing an investment portfolio, you purchase an amount of tuition credits or units (which you can do again periodically), subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of tuition in the future, no matter how much college costs may increase between now and then. As such, prepaid tuition plans provide a measure of security over rising college prices.
Flexibility. They are open to people of all income levels and offer the flexibility of changing the beneficiary or rolling over to another 529 plan once per year, as well as the option of accelerated gifting. Federal and state tax advantages given to prepaid tuition plans are the same as for college savings plans.
Financial support. For purposes of eligibility for federal financial support, prepaid tuition plans are deemed to be owned by the parents. However, individual institutions and states can treat them differently.
Participating plans. Your child is generally limited to your own state's prepaid tuition plan, and to the colleges that participate in that plan. If your child attends a different college, prepaid plans differ on how much money you'll get back.
Benefit reduction. Some prepaid plans have been forced to reduce benefits after enrollment due to investment returns that have not kept pace with the plan's offered benefits.
A Coverdell education savings account (Coverdell ESA) is a tax-advantaged education savings vehicle that allows you to save money for college, as well as for elementary and secondary school (K-12) at public, private, or religious schools.
Contribution rules. The beneficiary of the Coverdell ESA must be younger than 18 at the time the contribution is made. You (or someone else) make contributions to the account, subject to the maximum annual limit of $2,000. The total amount contributed for a particular beneficiary in a given year can't exceed $2,000, even if the money comes from different people. Contributions can be made up until April 15 of the year following the tax year for which the contribution is being made.
Investing contributions. You invest your contributions as you wish (stocks, bonds, mutual funds, certificates of deposit). You have sole control over your investments.
Favorable treatment for federal financial support. The assets are deemed to be owned by the parents.
Tax treatment. Contributions to your account grow tax deferred. Money withdrawn to pay college or K-12 expenses (called a qualified withdrawal) is completely tax-free at the federal level, and, typically, at the state level as well. If the money isn't used for college or K-12 expenses (called a nonqualified withdrawal), the earnings portion of the withdrawal will be taxed at the beneficiary's tax rate and subject to a 10 percent federal penalty.
Rollovers and termination of account. Funds in a Coverdell ESA can be rolled over without penalty into another Coverdell ESA for a qualifying family member. Also, any funds remaining in a Coverdell ESA must be distributed to the beneficiary when he or she reaches age thirty, unless the beneficiary is a person with special needs.
Income limits. Your ability to contribute depends on your income. To make a full contribution, single filers must have a modified adjusted gross income (MAGI) of $95,000 or less, and joint filers a MAGI of $190,000 or less. With an annual maximum contribution limit of $2,000, a Coverdell ESA probably can't go it alone in meeting today's college costs.
A custodial account allows your child to hold assets under the watchful eye of a designated custodian—assets she ordinarily wouldn't be allowed to hold in her own name. The assets can be used to pay for college or anything else benefiting your child (summer camp, braces, hockey lessons, or a computer).
Custodian. You designate a custodian to manage and invest the account's assets. The custodian can be you, a friend, a relative, or a financial institution. The custodian controls the assets.
Assets. You (or someone else) contribute assets to the account. The type of assets you can contribute depends on whether your state has enacted the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Typically contributed are cash, stocks, bonds, mutual funds, and real property.
Tax treatment. Every year, earnings, interest, and capital gains generated from assets in the account are taxable income of the child. Assuming your child is in a lower tax bracket than you, you'll reap some tax savings compared to holding the assets in your own name. However, this opportunity is limited because of special, "kiddie tax" rules that apply when a child has unearned income: Dependent children with unearned income (dividends, interest, and capital gains) in excess of $1,900 are taxed at the parent's marginal tax rate. This means full-time college students under the age of twenty-four may be subject to the tax. There is an exception for college students at least nineteen years old, and for eighteen-year-olds who are not yet in college and who can demonstrate that their earned income for the year exceeds one-half of their total support.
A custodial account provides the opportunity for some tax savings. However, the kiddie tax sharply reduces the overall effectiveness of custodial accounts as a tax-advantaged college savings strategy. There are other drawbacks: All gifts to a custodial account are irrevocable, and when your child reaches the age of majority (eighteen or twenty-one), the account terminates and your child gains full control of all the assets in the account. Some children may not be able to handle this responsibility, or they might decide not to spend the money for college.
Series EE and Series I (inflation-protected) bonds are types of savings bonds issued by the federal government offering a special tax benefit for college savers. The bonds can be purchased from most neighborhood banks and savings institutions or directly from the federal government. They are available in face values ranging from $50 to $10,000. You may purchase the bond in electronic form at face value or in paper form at half its face value. If the bond is used to pay qualified education expenses, and you meet income limits (as well as a few other minor requirements), the bond's earnings are exempt from federal income tax. The interest on these bonds is always exempt from state and local tax.
These bonds are backed by the full faith and credit of the federal government. Series I bonds offer the added measure of protection against inflation by paying you both a fixed interest rate for the life of the bond (like a Series EE bond) and a variable interest rate adjusted twice a year for inflation. There is a limit on the amount of bonds you can buy in one year, as well as a minimum waiting period before you can redeem the bonds, with a penalty for early redemption.
Your college saving decisions impact the financial aid process. Come financial aid time, your family's income and assets are run through a formula at both the federal level and the college/institutional level to determine how much money your family should be expected to contribute to college costs prior to receiving any financial aid. This number is referred to as the expected family contribution (EFC).
In the federal calculation, your child's assets are treated differently than your own. Your child must contribute 20 percent of his or her assets each year and you must contribute 5.6 percent of your assets.
For example, $10,000 in your child's bank account would equal an expected child contribution of $2,000 ($10,000 × .20). That same $10,000 in your bank account would equal an expected $560 contribution from you ($10,000 × .056).
Under the federal rules, an UGMA/UTMA custodial account is classified as a student asset. By contrast, 529 plans and Coverdell ESAs are considered parental assets if the parent is the account owner (so accounts owned by grandparents or other relatives or friends do not count). Distributions (withdrawals) from 529 plans and Coverdell ESAs used to pay the beneficiary's qualified education expenses are not classified as parent or student income on the federal government's aid form. This means some or all of the money is not counted again when withdrawn.
Regarding institutional aid, colleges tend to be stricter than the federal government in assessing a family's assets and ability to pay college costs. Most use a standard financial aid application that considers assets the federal government does not (such as home equity). Typically, though, colleges treat 529 plans, Coverdell accounts, and UGMA/UTMA custodial accounts the same as does the federal government, with the caveat that distributions from 529 plans and Coverdell accounts are often counted as available income.