College Savings PlansCollege Savings Plans - Education Savings Account (ESA) An Education Savings Account (formerly an Education IRA) is a tax-free account set up to build up savings for a child’s education. Education Savings Accounts have changed and now offer higher contribution limits and fewer restrictions. Who Can Invest Who Can Be a Beneficiary Investment Choices How Can the Money in an ESA Be Used Maximum Contribution Advantages of an ESA Money remaining in an account until a beneficiary reaches age 30 can be rolled over into an ESA for another family member. You can contribute to both an ESA and a Section 529 plan or prepaid tuition plan in the same year, and you can use assets from all of those plans in the same year for qualified expenses. Drawbacks College Savings Plans - Section 529 Plans A Section 529 plan is a state-sponsored investment program that lets you invest for higher education on a tax-advantaged basis. Every state and the District of Columbia offer or are planning to offer these plans. There are two types of Section 529 plans: College savings plans allow you to invest in a variety of portfolios made up of stocks, bonds, and cash investments or mutual funds that invest in those types of securities. Money in the plan can be used at any accredited college or university in the United States and even some qualified foreign schools. Prepaid tuition plans allow you to purchase tuition credits or certificates that can be used to pay future qualifying education costs. In essence, future tuition is being purchased at today's prices. Depending on the type of plan offered, the credits may only be used for qualified colleges, universities, or community colleges within the sponsoring state. Other types of prepaid plans allow contributions to be used at any accredited college or university, within or outside of the sponsoring state. You have to check within your individual state as to the specifics. Who Can Invest Who Can Be a Beneficiary Investment Choices How Can the Money Be Used Investment Limits 529 Plan Advantages Your withdrawals are federally tax-free as long as they are used for qualified higher education expenses, and there are no income limits to participate. Usually, you can't give more than $11,000 each year to another person without exceeding the annual gift tax exclusion. But with a 529 plan, you can contribute $55,000 to a beneficiary ($110,000 for married couples) and then prorate that gift over five years. (For example, a $55,000 gift to a 529 plan would count as an $11,000 gift this year and in each of the next 4 years.) You must file a federal gift tax return (IRS Form 709) to take advantage of this option. Residents of some states can deduct all or part of their contributions to their state’s plan from state income taxes, and in a few cases states even contribute matching funds.
What are the drawbacks? Your choice of investments is limited to those offered by the plan. If you withdraw the money for any reason other than education (or in certain circumstances as permitted by law), your capital will be returned (assuming there hasn’t been an investment loss), but you'll owe tax on any gains and, depending on the circumstances, a 10% penalty. The federal tax exemption on earnings withdrawn for qualified higher educational expenses will be removed after December 31, 2010, unless the law changes. A few states impose state income taxes on any earnings withdrawn from a 529 plan sponsored by another state. College Savings Plans - UGMAs/UTMAs Custodial accounts are a simple, easy way to give money or transfer assets to children under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Any gift or transfer to the account is irrevocable, but an adult custodian (usually the contributor) controls the account until the child reaches adulthood or the age specified on the account, which can range from 18 to 25, depending on the law of the state in which the account is established. Who Can Invest In An UGMA/UTMA Who Can Own an UGMA/UTMA Who Makes Decisions about the Account Investment Choices How Can the Money Be Used Investment Limits Advantages of an UGMA or UTMA Donors may reduce their income taxes by transferring income-producing assets to a child who is probably in a lower tax bracket. If the child is under 14 at the end of the tax year, the first $750 of the child’s investment income is exempt from federal income tax; the second $750 is taxed at the child’s rate; and any income in excess of $1,500 is taxed at the parents’ rate. If the child is 14 or older, then the investment income is taxed at the child’s rate, which is usually lower than the parents’ rate. The child may also take a standard deduction against his or her unearned income. Donors may reduce the size of their taxable estate by giving to a child’s UGMA/UTMA. If your estate is likely to be subject to estate tax, you should name someone other than yourself as the custodian of the UGMA/UTMA, or it may be taxed as part of your estate if you die before the child is old enough to take over the account. Drawbacks There are 2 main drawbacks to using an UGMA/UTMA account. Loss of control. Once the child gets control of the account, he or she can spend the money on anything, there are absolutely no limitations. You have no recourse even if you hoped the money would be spent on the child’s education, a down payment on a home for the child, or the child’s wedding. Life’s uncertainties. If you encounter financial difficulties, the money in the UGMA/UTMA is out of your reach. Even if you become disabled or lose your job, the money remains the property of the child. College Savings Plans - Roth IRA Most Roth IRAs are retirement-investing vehicles, but some investors use them to pay for college. Roth IRAs have tax advantages and flexibility that can make them an attractive way to save for college. You control how the money is spent. Your investment can grow tax-free under certain conditions. You can withdraw these retirement savings before age 59½ without incurring early withdrawal penalties if you use the investment for qualified education expenses. Investment earnings on a Roth IRA are tax-free when you reach age 59½ and have held a Roth IRA for at least 5 years. For a complete look at Roth IRA’s go to the retirement investing page. College Savings Plans - Traditional IRA You can withdrawal money from a traditional IRA without paying a penalty for qualified college tuition and expenses but you will have to pay taxes on the income. This makes using a traditional IRA a less desirable college savings investment but it is possible to use these funds. For more information follow the above link. College Savings Plans - Regular Savings and Investment Accounts If you save in a regular investment (stock, bond, cash, mutual fund) you will have total control but will pay all of the taxes. How do you decide what college savings plan is best for you? If you think there’s a strong chance that your child will follow a career path that bypasses college, you may want to avoid certain college-investment programs. Education Savings Accounts (ESAs) and Section 529 plans both impose penalties if the money isn’t spent on qualified education expenses. A Roth IRA can be held onto and used for your retirement if your child does not use it for college expenses. An UGMA/UTMA account is the child’s property and must be turned over to the child when he or she reaches a certain age (between 18 and 25, depending on state law). Do you want to control over how the money is invested in your college savings plan? ESAs, UGMA/UTMA accounts, Roth IRAs, and tax-managed funds all provide you with control over how your college money is invested. Many 529 plans provide you with some discretion over how your money is invested, but your choices are limited to the investments offered by the plan. Do I want to control how the money’s spent? This is an especially important consideration with UGMA/UTMA accounts, which come under the complete control of the child some time between the ages of 18 and 25. The child may choose to spend the money on something other than college, including things you find wasteful. ESAs and Section 529 plans can be distributed only for qualified education expenses, while your family may need the money for other, unforeseen purposes. A Roth IRA, which is intended to be a retirement account, limits when and how you can spend some of the money in the account. Each of these college savings plans has both advantages and disadvantages, pick the one that is best for you.
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