Presented by Roberta L. Nestor
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 both 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 education expenses. These expenses may include tuition of up to $10,000 for elementary or secondary public, private, or religious school. In addition, these funds may be used for “qualified higher-education 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 (i.e., utilizing the CT CHET plan will allow for a state income tax deduction for a maximum contribution of $10,000). 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. In addition, because you are the account owner, the account is considered your asset, not the beneficiary’s, for purposes of applying for federal financial aid—which means it is assessed at a lower rate than a student-owned asset.
Earnings in a 529 plan grow federal tax free and will never be taxed as long as the money withdrawn is used for qualified higher-education expenses, which include tuition, room and board, fees, books, and equipment. Distributions not used for qualified higher-education expenses are allowed, but they are subject to federal income tax plus a 10-percent 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. In 2018, individuals can make tax-free gift contributions of up to $15,000 per beneficiary per year (or $30,000 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 $75,000 contribution (or $150,000 for married couples) per beneficiary.
Bottom line? The expansion of the 529 plan’s qualified expenses to include elementary and secondary private school education and the low impact on the Free Application for Federal Student Aid (FAFSA) for higher education have made this tool very attractive.
Coverdell Education Savings Account
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 account remains in control of the account and can withdraw funds or change the beneficiary to another family member as he or she sees fit. As a result, the Coverdell account has a low impact on financial aid.
The assets in a Coverdell account 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 account 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 account is $2,000 per beneficiary per year, and contributions can be made only up until the beneficiary reaches age 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 account and the 529 plan is that any unused funds must be distributed to the beneficiary at age 30, with earnings taxed as ordinary income, plus a 10-percent penalty. (Keep in mind that 529 plans have no such rules regarding the distribution of unused funds.) A Coverdell account can be used for elementary and secondary school expenses in addition to college.
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 of age—the child gains complete access and control of the assets and can use them for whatever he or she wishes. The income earned in a custodial account is taxable to the child.
The first $1,050 of unearned income is tax free, the next $1,050 is taxable to the child, and anything more than $2,100 is taxed in accordance with the applicable “kiddie tax” rates. Because the asset is in the child’s name, it counts as a student-owned asset for college financial aid, leading to a much larger impact on financial aid than a 529 plan or a Coverdell account would have. But like a Coverdell account or 529 plan, 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 whichever plan you choose aligns with your education savings goals.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
Roberta L. Nestor is a financial advisor located at Nestor Financial Network, LLC, 491 New Haven Avenue, Milford, CT. She offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. She can be reached at 203-876-8066) or firstname.lastname@example.org.
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