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Saving for college: the options

June 24, 2011
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529 Plans in the Intermediary Channel

Wednesday, June 29th from 2 pm – 3 pm Eastern Time

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Remember when saving for college was simple? Your parents opened a passbook savings account in your name at the local bank, and all your birthday money and everything that you earned from mowing lawns went into it.

It’s not so simple today. In addition to the traditional UTMA-UGMA custodial accounts, there are now Coverdell accounts and 529 plans — each with their advantages and disadvantages. Let’s take a quick look at each of these three savings vehicles:

 

UTMA-UGMA accounts

  • Stands for. Uniform Transfers to Minors Act; Uniform Gifts to Minors Act.
  • Created. Laws authorizing these accounts have been enacted in each state. UTMA and UGMA are model state laws, developed in 1983 and 1956, respectively. Most states have adopted the newer UTMA law, but some still use the UGMA law.
  • How they work. Account is opened in the name of a child. Custodian (usually a parent) administers the account on behalf of the child until the child reaches the age specified in state law (normally 18 or 21). Child has unrestricted access to assets in the account upon reaching that age.
  • Taxation. Contributions to the account are non-deductible. Income earned below threshold specified by IRS is taxed at child’s rate; income above that threshold taxed at parent’s rate.
  • How to get one. Most brokers and mutual fund firms will open an UTMA-UGMA account for a child.
  • The bottom line. Great for saving small amounts, but taxes and loss of parental control at 18 or 21 make other options more appealing for larger amounts.

 

Coverdell Education Savings Accounts

  • Named after. Senator Paul Coverdell of Georgia.
  • Created. In 1997 in the Taxpayer Relief Act, along with Roth IRAs.
  • Former name. “Education IRAs.” They became Coverdell ESAs in 2002 when contribution limits were increased as part of the “Bush era tax cuts.” These tax cuts were set expire at the end of 2010 but were extended by President Obama.
  • How they work. Account is opened on behalf of a beneficiary who is under age 18 or a special needs beneficiary.
  • Taxation. Contributions to the account are non-deductible. Income earned accrues in the account tax-free. Withdrawals for education expenses are untaxed in theory (though see drawbacks). Amounts that haven’t been withdrawn revert to child at age 30 (though subject to taxes and penalties).
  • Drawbacks. Contributions limited to $2,000 per year (and that’s after the 2002 increase) and limited to taxpayers earning less than IRS-specified threshold. Complicated tax rules (involving coordination with the Hope and lifetime learning credits and the tuition deduction) apply to withdrawals, which may end up being partially taxed.
  • How to get one. Most brokers and mutual fund firms will open a Coverdell account for a child.
  • The bottom line. Nice features, but restrictions on contributions limit their usefulness.

 

529 Plans

  • Named for. The section of the tax code that authorizes them.
  • Official name. Qualified tuition programs.
  • Created. In 1996 in the Small Business Job Protection Act.
  • Types. Prepaid tuition plans and college savings plans.
  • How they work. Account is opened on behalf of a designated beneficiary (the student or future student).
  • Taxation. Contributions are non-deductible for federal income tax purposes, but may be deductible for state income tax purposes. Income earned accrues in the account tax-free. Withdrawals for education expenses are untaxed. Balances in the account may be transferred to a family member.
  • Advantages. Limits on contributions (currently $13,000 per year without gift tax or $65,000 once in a 5-year period) are significantly higher than for Coverdell accounts. No limitations on income of donor.
  • How to get one. Plans sponsored by a state or an educational institution. State plans may be available directly or through a broker.
  • The bottom line. The preferred option for college savings today because of their tax advantages, parental control and high contribution limits.

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