College Planning Basics
The high cost of college education leaves many families wondering how they can afford a college education for their children. The Economic Growth and Tax Relief Reconciliation Act of 2001 has made certain college planning tools more popular.
Section 529 Plans
Section 529 Plans may not provide the total college funding for all families but the new tax law makes it the most attractive option by far. The biggest benefit of the Section 529 Plan is that when the money is withdrawn for the purpose of higher education it is tax-free at least until December 10, 2010 unless extended. Many believe it will likely be extended.
Investors may now contribute up to $305,000 per student (maximums vary by state), can have accounts in multiple state plans, and the account grows tax-free or at least tax deferred. According to the IRS, you can put up to $11,000 per year per child or grandchild into a state-sponsored qualified tuition program or 529 plan. The investment grows income tax free and need not be from your own state. There is no estate tax penalty so assets can be passed along to heirs. There is a 10% penalty and federal income tax if you use the money for any other purpose besides your child’s education.
The new tax law also makes these plans a favorable estate planning tool since contributions made to the plan are no longer a part of an estate. And the funds are still controlled by the account owner, not the beneficiary. Also new for 2002 is the ability to transfer the plan to first cousins. This makes the 529 plans an even more attractive estate planning tool, as older clients can reduce their estates by contributing to their grandchildren’s educations.
The Coverdell Education Savings Account was expanded for 2002 but it still offers fewer benefits than 529 Plans. The maximum contribution per year per child is $2,000, which is still low for college funding objectives, and there are income limitations. There are no income limitations on Section 529 Plans. With the Coverdell Savings Plan, assets are still transferred out of the estate and like 529s are subject to the same penalty for early withdrawal and income tax. Coverdell Plans must be used by age 30; no such limit applies to 529 plans. One advantage of the Coverdell Plan, however, is that fund can be withdrawn for qualifying elementary and secondary school expenses, while a 529 plan is specifically for college level education.
Pre-Paid 529 Plans
Most states have a “pre-paid” college savings plan. However, they are state specific, meaning that you are paying for your child to go to a school in that state and are "pre-paying” the tuition, as opposed to a 529 “savings” plan, which is a true savings plan. Verify how these “pre-paid”, state-sponsored plans work before you invest. Careful scrutiny might reveal that you may not get the benefits you were expecting. However, prepaid plans reduce financial aid dollar for dollar, as opposed to savings plans.
Uniform Gift to Minors and Uniform Transfers to Minors Acts
Prior to 529 plans, it was common to use these two types of accounts referred to as UGMA/UTMA accounts to pay for a college education. These accounts are still an option but the have several drawbacks. The first being the beneficiary gets control of the account when he or she turns 18 which means you have no say in how they spend the money. There is no ability to change the beneficiary and while the taxes may be lower there is no tax deferral. The assets are also subject to a 35% assessment when taken into consideration for financial id.
As with any tax law, there are many exceptions that you must take into consideration when choosing your college saving vehicle.