By Randy Neumann
One of the biggest challenges for families saving for their children’s college education is that there are so many college savings plans to choose from, and one size does not fit all. Which option(s) is right for you depends, in part, on the age of your child, family income, potential for financial aid, and the expected cost of college. Here are the major college savings options to consider.
529 college savings plans
– Features of these popular state-run plans include:
• Investments grow tax deferred and withdrawals for qualified college expenses are free of federal tax.
• Some states give tax breaks on the contributions.
• Over $250,000 can be invested in many plans.
• Investor retains control, and can change beneficiaries.
• There are no income restrictions.
• Their impact on financial aid is less than many of the other alternatives.
• There can be some significant estate tax benefits available.
While 529 plans can be an especially good alternative for high-income families wishing to save a substantial amount for college, investment options are usually limited, as is the ability to move funds around within the plan.
Coverdell education savings accounts – You can contribute up to $2,000 a year per child, but there are income restrictions ($95,000 for a single taxpayer; $190,000 for married couples). Earnings are federal income tax exempt if used for qualified education expenses. Coverdells offer many more investment choices than 529 plans, and often have lower expenses.
Coverdells can be a good option for people who can save only a small amount each year or who may want to fund a Coverdell before moving on to other alternatives. Their impact on financial aid is now the same as that of 529 plans – the account is considered the parent’s asset instead of the student’s, potentially resulting in more aid.
Pre-paid tuition plans – Under these plans, you can buy part or all of a school’s future tuition bill at today’s prices. Once offered only by some states, there are now private prepaid tuition plan alternatives. Earnings from either private or public plans are federally tax-exempt.
It can be a good option for conservative investors who want to lock in tuition costs and who know what college their children will likely attend. But be aware, under current rules, prepaid plans reduce financial aid dollar-for-dollar.
Custodial accounts – Investments are held in the name of a minor, but are managed by the custodian (usually a parent). This arrangement provides some tax benefits, especially for higher-income families because they shift capital gains taxes to their lower-income children. Unlike some other college funding alternatives, there are no income restrictions. But contributions over $12,000 a year per parent are subject to gift tax, and the assets remain in the parent’s estate in some instances. Custodial accounts present three major drawbacks. One, the gifts are irrevocable. Two, the child assumes control of the assets when he or she becomes a legal adult, and may prefer a Corvette to college when the time comes. Three, the assets typically count more heavily against financial aid, though some colleges are changing their policies in this area.
Series I and EE Savings Bonds – The interest earned from these bonds is free of federal tax as long as it is used to pay for tuition and fees. However, the benefits may be reduced by other education tax breaks such as the HOPE Scholarship.
Taxable investments in the parent’s name – The advantages include nearly unlimited investment options, no income restrictions, retention and control of the assets, and the flexibility of using the assets for something other than college if necessary. The major disadvantage is the taxes on earnings. You can minimize that by gifting the assets to your child when it’s time for college and having them sell the assets; however, you may have to pay a gift tax.
Individual retirement accounts – Money taken out of a traditional IRA is free of the 10 percent early withdrawal penalty (but not ordinary taxes), if it’s used for qualified education expenses. Withdrawals of Roth IRA contributions are tax free and even the earnings may be tax free in some situations.
Well, you’ve seen an array of college savings plans available. Which one(s) are right for you? If you’re a regular reader of this column, you know the answer – it depends!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann, CFP® is a registered representative with and securities and insurance offered through LPL Financial. Member FINRA/SIPC. He can be reached at 600 East Crescent Avenue, Suite 104, Upper Saddle River, NJ 07458, 201-291-9000.