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Types of College Savings Plans and How They Work

| November 02, 2017
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Saving for your child’s college education has been an increasingly pressing issue given the increase in tuition and other higher education costs. To address this, there are several types of college savings plans available today. In addition to the longstanding UGMA (Uniform Gift to Minor’s Act) and UTMA (Uniform Transfer to Minor’s Act), 529 plans and Coverdell education savings accounts (ESA) also exist.

UGMA and UTMA Accounts

These education savings accounts are little more than custodial accounts that hold and protect assets for minors until they reach the age of 18 (or other state-dictated age of majority). Perhaps the greatest difference between these two types of custodial accounts is that the UTMA is more flexible than the UGMA in that it permits minors to own other types of property like real estate, royalties, fine art and patents, and it also allows transfers to occur via inheritance. However, because these types of custodial accounts are considered among the child’s assets, they may affect financial aid procurement. (For more, see: Using 529 Plans to Save for College.)

Eligible expenses: Unlike other college savings accounts, any expense that benefits the child - not just educational expenses - may be withdrawn at the behest of the custodian. Additionally, once the child reaches the age of majority, she/he can use the money without any limitations.

Contribution limits: While there are no contribution limits, you must be cognizant of how large gifts affect your lifetime estate and annual gift tax exclusions. Consulting with a knowledgeable financial advisor is highly recommended.

Tax benefits: These accounts permit bond, stock and mutual fund investments. Because these assets are considered to be the minor’s property, an amount of investment income remains untaxed while the remainder is taxed at the child’s - not the parents’ - tax rate.

Unused funds: Any unused funds must be distributed once the child reaches 18 or the maximum age permitted for custodial accounts in one’s state.

529 Plans

A 529 plan is a college savings pan that is sponsored by a state or state agency for U.S. residents who are 18 years of age or older. Funds saved in this plan can be used for tuition, books and other education expenses. These plans are applicable to:

  • Two-year colleges.
  • Four-year universities.
  • U.S. vocational schools.
  • U.S. technical schools.
  • Eligible foreign institutions.

There are two types of 529 plans: college savings plans and prepaid tuition plans. Whereas the college savings plan lets you save money in an investment account, a prepaid tuition plan pools your contributions along with other investors so as to prepay future college expenses at today’s costs. (For related reading, see: Education Savings Account: Avoiding Taxes on Distribution.)

In order to open a 529 plan, you must:

  • Be a U.S. resident.
  • Be 18 years of age or older.
  • Have a U.S. legal and mailing address.
  • Have a social security number or tax ID.

The plan can be opened by the individual who will be using it, parents and grandparents. The account’s owner retains full control of the account with respect to asset distribution and investment decisions.

Benefits of 529 plans: 529 plans generally have higher lifetime contribution limits than other education savings accounts. Additionally, there are typically neither income limits nor age restrictions for contributors and beneficiaries. 529 plans boast significant tax advantages in that any earnings are federal income tax deferred, as well as in many cases being eligible for state tax deductions. Additionally, distributions for qualified expenses are also tax free.

Withdrawals: Withdrawals from a 529 account are available at any time and for any reason. However, if the funds are not used for qualified higher education expenses, earnings are then subject to federal income taxes in addition to a 10% federal penalty tax and possible state and/or local taxes. If, however, the beneficiary receives a scholarship or attends a U.S. military academy, the scholarship amount/cost of attendance may be withdrawn without being subject to the 10% federal penalty tax. (For related reading, see: Choosing the Right 529 Education Savings Plan.)

Coverdell Education Savings Accounts

Like a 529 plan, a Coverdell ESA is a tax-advantaged savings account for qualified education expenses for a named beneficiary. While they have similar goals as other education savings accounts, Coverdell ESAs have their own set of advantages and disadvantages.

Advantages: Among the greatest benefits of Coverdell ESAs is that qualified withdrawals are free from federal income tax and, in some states, exempt from state tax as well. You can open a Coverdell ESA with many banks, mutual fund companies and other financial institutions and you can fully customize your portfolio. Additionally, you can transfer money among a company’s different investments or transfer the account from one trustee to another, something not permitted with 529 plans.

Disadvantages: A primary disadvantage is that these accounts cannot be opened for a beneficiary over age 18, nor can any contributions be made to a beneficiary once she/he turns 18 unless the beneficiary has special needs. Further, an already established Coverdell ESA cannot continue after the beneficiary reaches 30 years of age. Another disadvantage is that withdrawals used for purposes other than qualified education expenses are subject to income tax, a 10% federal penalty and possible state penalties.

The annual contribution limit for a Coverdell ESA is $2,000 per beneficiary until age 18, which is much less than contribution limits for most 529 plans. Further, if you earn over a certain income amount, you may not be able to contribute to this type of fund as allowable contributions are slowly reduced based on your modified adjusted gross income.

Finally, the account owner does not retain as much control over the account as would be the case with a 529 plan. In other words, once the beneficiary reaches the age of majority, control typically passes to him/her. Further, once the beneficiary reaches age 30, the funds must be distributed within 30 days and may be subject to taxes and penalties. (For more from this author, see: Why You Should Start Financial Planning Early.)

Disclaimer: There is no guarantee that the plan will grow to cover college expenses. In addition, depending upon the laws of your home state or designated beneficiary, favorable state tax treatment or other benefits offered by such home state for investing in 529 college savings plans may be available only if you invest in the home state's 529 college savings plan. Any state-based benefit offered with respect to a particular 529 college savings plan should be one of many appropriately weighted factors to be considered in making an investment decision. You should consult with your financial, tax or other advisor to learn more about how state-based benefits (including any limitations) would apply to your specific circumstances and also may wish to contact your home state or any other 529 college savings plan to learn more about the features, benefits and limitations of that state's 529 college savings plan. You may also go to www.collegesavings.org for more information.

Todd Wilhoit contributes articles for Investopedia.com. See this one and more here.

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