Saving for College: What’s the best way?

My experience as a parent and an accountant lead me to one very solid conclusion: college is expensive.  This year’s stats from the College Board reveal that the average yearly tuition at a public college is $22,958 for out-of-state residents.  That number jumps to $31,231 for private schools.  And costs are rising — way ahead of the rate of inflation and far beyond the ability of most families to pay for it.  It’s a bad situation that’s getting worse.

If your children are college-aged, you’re likely already navigating the financial aid waters, including making the tough decision about whether to take out loans to finance college.  But if your children are younger, you may be looking for ways save for college, and do so in a way that maximizes growth potential while minimizing associated costs like taxes and fees.  Let’s look at two of the most popular vehicles for college savings, 529 plans and the Uniform Transfers to Minors Act (UTMA), and determine which is right for you.

529 plans are one of the most popular college savings tools because they allow for tax-free growth and withdrawals, as long as the funds are used for approved educational expenses.  Parents put money into the account and retain control of it.  529 plan accounts can be used for both college and trade schools (graduate and special needs schools, too).  The account beneficiary can also be changed to another family member with no penalty or taxes.  If funds end up not being needed for education, then they can be easily withdrawn. You simply pay the tax and a 10% penalty on profits.   Legally known as “qualified tuition plans,” 529s are sponsored by states, state agencies, or educational institutions, and are authorized by Section 529 of the Internal Revenue Code.

The Uniform Transfers to Minors Act (UTMA) provides a mechanism under which gifts can be made to a minor without requiring the presence of an appointed guardian for the minor. The Act allows the donor of the gift to transfer title to a custodian who will manage and invest the property until the minor reaches a certain age. The age is generally 21, but is different in some states (usually 18 in those cases).  UTMA satisfies the IRS’ requirements for qualifying a gift of up to $14,000 for exclusion from the gift tax. It is a more flexible extension of the Uniform Gifts to Minors Act (UGMA), and allows the gifts to be real estate, inheritances, and other property.

Both 529 plans and the UTMA are workable options for saving for college. When considering which method is best, it’s important to examine the following questions:

  1.  Who do you want in control?

Parents who contribute large sums to college savings accounts will likely expect those funds to actually be used for college.  With 529 accounts, that is all but guaranteed. If the funds are used for anything other than qualified educational expenses, the earnings withdrawn from the account are hit with a 10 percent penalty, and withdrawals are also subject to federal income tax.

On the other end, controlling the use of the funds is significantly more difficult with a UTMA account. A UTMA account is designed to pass a large sum of money, real estate, or other inheritance to a minor, and once the child reaches adulthood (18 or 21, depending on the state), the control of the account is completely – and permanently – transferred.  Parents then cannot dictate how the funds are used. And unlike 529s, UTMAs have no stipulations on expenditures.

Bottom line? Go with a 529 if your main objective is that your gifts fund higher education and nothing else.

  1. Are you okay with the tax implications?

People generally want to avoid paying more taxes, and the rules governing 529 ensure that money isn’t taxed so long as funds in the 529 are used for educational purposes.  

No such protection for education expenses exists with a UTMA account.  Beneficiaries of a UTMA are subject to income taxes regardless of how they choose to spend the funds within the account.  UTMAs are considered assets of the child and the income they produce (including dividends or interest) will be taxed as income.  There is a $2,100 ‘kiddie tax’ threshold, above which all excess earnings are taxed at the parents’ highest marginal rate, which is based on parental income. This is extremely disadvantageous for both the child and parents.

Bottom line?  Opt for a 529 plan if you’re passionate about saving tax money.

 

  1. In all likelihood, will you be applying for other financial aid?

Unless you’re extremely wealthy, the answer to this is most likely yes.  An overwhelming number of college students apply for and receive some sort of aid — loans, grants, etc., and a UTMA account can severely  impact your ability to receive other financial aid.

After families fill out the FAFSA, the Free Application for Federal Student Aid, parental income is the first factor considered when determining a student’s expected family contribution. After that, assets of both the parent and the student and the student’s income are examined. With a UTMA, the money is considered a child’s asset.  With a 529 plan, the balance is considered a parental asset. Because it belongs to the student, the UTMA will be given much higher weight in determining financial aid, making it much more difficult to qualify.

Bottom line? Skip the UTMA if additional aid is in your future.

In general, a sound 529 plan is the best option for most families.  It allows parents and grandparents to reduce their estates for tax purposes, and allows for more control over the funds and less taxation overall.  Very savvy investors may prefer a UTMA because of the greater investment choices that are available (UTMAs are open to investments of all different kinds, just like a normal brokerage account or IRA), but this position is somewhat rare.  Be sure to check-in with your accountant and financial advisors before making these (or any) investment decisions.

 

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