Saving money for college is one of the most important investments most people will make in their lifetime. Fortunately, there are many investment options for college savings, with particular merits, and certain caveats to bear in mind. Investing parameters to consider include the length of time set aside for savings, the financial return on the investment, whether your child will choose college for his future, and perhaps most importantly, the tax ramifications of the investment choices.
A popular college savings vehicle, known as a 529 Plan, is essentially a qualified tuition plan sponsored by a state or educational institutions that is authorized by Section 529 of the Internal Revenue Service. An account holder may either invest in a prepaid tuition plan, or a college savings plan. A prepaid tuition plan allows the account holder to purchase units or credits at participating colleges and universities for future tuition (and possibly room and board), while an account holder of a college savings plan can use the withdrawals at any college or university. All 50 states and the District of Columbia offer some type of 529 plan.
The tax advantages to 529 plans are that the earnings are not subject to state or federal tax if used to cover the cost of higher education and some states allow a deduction for contributions to 529 plans. An additional benefit is that 529 plans can be funded by parents, grandparents, aunts & uncles, etc. There is a special gift tax rule that allows five years of 529 plan contributions to be made at one time without gift tax consequences provided that no other gifts are made to that donee during those 5 years. For 2014, $70,000 ($14,000 annual exclusion times 5 years) can be deposited in a 529 plan by each donor. If the 529 investment is withdrawn and not used for college, the owners will be subject to income tax on the earnings plus a 10% federal tax penalty. Some states impose rules limiting annual portfolio allocations. Market risk must also be considered. If you have a child with a 529 plan who decides college is not for them, the account may be transferred to another family member.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts (formerly called an “Education IRA”) differ from 529 plans in that the funds can be used for primary and secondary education in addition to higher education. They are similar to 529 plans because the earnings are not taxable when used for qualified education expenses but are taxable with a 10% penalty on earnings if not. A contribution to a Coverdell Education Savings Account and a 529 plan can be made in the same year, but the contribution to the Coverdell Education Savings Account is limited to $2,000 each year. In addition, there are income limitations on the contributor to be eligible to make contributions. When the beneficiary reaches age 18, contributions can no longer be made and at age 30, the account has to be closed. Another disadvantage is that state tax deductions are not allowed for these contributions.
Custodial Accounts Custodial accounts created under the Uniform Gifts/Transfers to Minors Act allow funds to grow in your child’s name. Gifts to these accounts are subject to the annual gift limits. Advantages of UGMA/UTMA gifts are that investment decisions are more flexible and there are no restrictions on the withdrawals. Disadvantages are that the earnings may be subject to the kiddie tax, meaning that they are taxed at the parent’s rate rather than the child’s rate. The parent also loses control of the funds once the child reaches the age of majority, which may differ on a state by state basis.
Mutual funds provide flexibility through diversification of assets. Depending on the firm or firms managing the funds, these investment vehicles can offer great returns. Investors will be subject to taxes on gains from their dividends; however they have the advantage of being able to manage risks by balancing stocks and bonds in one portfolio. To some investors it may seem frightening that someone else is managing their money, but historically mutual funds, especially those in stocks, have proven to show great returns. So risk management and diversification may appeal to some, but don’t expect to find the income tax breaks of IRAs or 529s here.
Savings Bonds and Stock Investments
Other college saving options include the basics, such as government savings bonds or individual stock investments. These alternatives can represent the polarity of investment risk. Saving for college with bonds requires a long time of accruing interest and the investments are limited at $10,000 face value annually. Savings bonds are not taxed on their accrued interest, but their annual cap and slow growth limit their utility. Interest earned on certain Series EE or I bonds is tax free is used for qualified higher-education purposes. Investing in stocks without a broker can be risky, and land any investor in a situation of fast gain or sharp losses. Investments in stocks are taxed on capital gains and dividend income, so even if you do make some money, don’t expect to get off scot free.