My client Betsy recently revealed her desire to help two young family friends save for college. Although these minors are not her grandchildren, Betsy can still help them. She shares the desire many grandparents have: to help their grandchildren receive a post-secondary education without being saddled with a lot of debt.
There are two terms to understand:
- Qualified college expenses include tuition, required school fees, books, special needs equipment, computers and related equipment, some room and board costs.
- Non-Qualified expenses include health insurance, optional fees (such as parking permits), transportation, and student loan payments.
Betsy has many options available to her. Following is a brief Overview of three possibilities: 529 college savings plan, Coverdell Education Savings Account and UGMA/UTMA account.
What are these plans?
A 529 Plan is a college savings plan which allows for tax-deferred growth of its assets. While contributions to a 529 plan are not tax deductible from federal income taxes, the assets grow tax-deferred. 529 plans are offered by most states, and there is a 529 plan offered by a group of private colleges and universities. You can invest in any 529 plan. Regardless the 529 plan you choose, the funds can be used for any qualified post-secondary institution. This includes trade and vocational programs, public and private colleges and universities across the United States, and some foreign colleges and universities. Additionally, up to $10,000 can be used each year for K-12 school tuition.
Coverdell Education Savings Accounts (ESA) began as Education IRAs. Congress later expanded its benefits and renamed it the Coverdell Educational Savings Account (ESA). They are similar to 529 plans in that earnings grow tax-deferred.
UGMA/UTMAs: UGMA stands for “Uniform gift to Minors Act” and UTMA stands for “Uniform Transfer to Minors Act.” Any individual can set up one of these custodial accounts for the benefit of a minor who is the named beneficiary. With UGMA/UTMA, accounts the custodian must manage the account in the best interests of the beneficiary.
Who owns the account?
529 Plan: When you set up the 529 plan, you are the account owner. You name the beneficiary of the account, choose from your plan’s investment options, and decide how the money will be spent. You can also choose to donate to a 529 plan owned by the student or his parent.
Coverdell ESA: The owner of the account is typically the person who sets up the account. The account owner makes investment and spending decisions.
UGMA/UTMA: The child whom the account benefits is the account owner. While the child is a minor, you can serve as the custodian of the account or you can appoint another individual, such as a parent, or a financial institution.
How can the funds be invested?
529 Plan: The account owner selects from the funds offered by the 529 plan.
Coverdell ESA: Coverdell accounts can be invested in a broad range of securities such as individual stocks, bonds, CD’s, or mutual funds. Coverdell ESA’s are not permitted to directly own real estate, precious metals, collectibles, or partnerships in private businesses.
UGMA/UTMA: UGMA and UTMA accounts can be funded with anything permitted under your state’s laws, including stocks, bonds, mutual funds and other securities.
How much can you contribute?
529 Plan: The federal government treats contributions to 529 plans as gifts subject to the $15,000 annual gift tax exclusion. You can elect to contribute up to $75,000 in one year and treat this, for federal tax purposes, as if the gift was made over five years. Over all, the total amount you can contribute is determined by your plan. Many allow you to contribute more than $300,000 per beneficiary. Contributions to 529 plans are non-deductible from federal taxes, but many states offer tax credits or deductions when you invest in your home state’s plan.
Coverdell ESA: Annual contributions are limited to $2,000 per year per child. Contributions are non-deductible and can be applied to the annual $15,000 gift tax exclusion. Contributions must stop once the beneficiary reaches age 18. The donor’s income must be below certain limits. States do not offer a tax deduction for investing in a Coverdell account.
UGMA/UTMA: There is no limit to how much you contribute, although any gifts over $15,000 per year to one individual are subject to gift taxes. Contributions are not tax deductible.
How are the account earnings taxed:
529 Plan: Earnings grow tax free. Withdrawals are not taxed when used for qualified education expenses.
Coverdell ESA: Earnings grow tax free. Withdrawals are not taxed when used for qualified education expenses.
UGMA/UTMA: The first $1,050 in unearned income is tax exempt. The next $1,050 in unearned income is taxed at the child’s tax rate. Unearned income exceeding $2,100 is taxed at the parents’ tax rate.
For what can the money in the account be used?
529 Plan: These accounts are designed to be used for qualified college expenses and up to $10,000 in K-12 tuition. If the money withdrawn is used for other purposes, the earnings are subject to federal income tax and a 10% penalty.
Coverdell ESA: These accounts can be used for qualified college expenses. Unlike 529 plans, Coverdell ESA can also be used for a broad range of K-12 education expenses including unlimited tuition, room and board, and uniforms. If the money withdrawn is used for other purposes, the earnings are subject to federal tax and a 10% penalty.
UGMA/UTMA: There are no restrictions on how the money can be spent, as long as it is for the benefit of the child. Once the child reaches the age of majority (as defined by state law) the account must be turned over to the beneficiary. He or she can then use the money as they choose, including non-educational expenses.
How does the plan impact the student’s need-based financial aid?
529 Plan: This is complex and depends on who owns the account. In general, if you, as a grandparent or other individual, own the 529 plan account, the money in the account does not affect the student’s initial financial aid eligibility. Since neither the student nor the parent own the account, it is not reported when the student is trying to qualify for aid. Once you withdraw money and make a payment to the college, however, the money will be counted the following year as the student’s untaxed income. This will increase the student’s “Expected Family Contribution,” reducing the student’s financial need and her eligibility for need-based aid.
If you contribute to a plan owned by the student or the student’s parent, the account will be considered a parent asset when initially applying for aid. A 529 plan can reduce eligibility for need based aid by up to 5.64% of the account value. After the student qualifies for aid, however, money withdrawn to pay college bills is not counted as the student’s income and does not impact continued eligibility for need-based aid.
Coverdell ESA: The impact on the student’s need-based financial aid is the same as with 529 plans.
UGMA/UTMA: Since an UGMA/UTMA account is the student’s asset, it will reduce the student’s eligibility for aid.
Are there any time limits on when the money must be used?
529 Plan: No, unless the 529 plan has time limits.
Coverdell ESA: You can only contribute until the child reaches age 18. The funds must be used by the time the student reaches age 30.
What happens if the beneficiary doesn’t attend college?
529 Plan: You can name another member of the beneficiary’s family. You can also take back the money for yourself at any time for any reason. This is subject to income tax and a 10% penalty on earnings. If you are trying to qualify for Medicaid, the money saved in your 529 plan will be considered available assets that must be spent on your care before Medicaid will begin.
Coverdell ESA: You can name another member of the beneficiary’s family. Any unused funds by the time the beneficiary reaches age 30 must be given to the beneficiary or rolled over for the benefit of another younger member of the original beneficiary’s family.
UGMA/UTMA: Contributions are irrevocable gifts. There is nothing you can do.
In addition to these three savings vehicles, there are additional ways to help grandchildren pay for college including paying tuition directly to the school, setting up a trust, and establishing and using a ROTH IRA.
All of these avenues for helping grandchildren, or in Betsy’s case, family friends, pay for school are complex and have many rules not included in this post. For more information, visit savingforcollege.com is a helpful resource.
Before setting up any plan, I recommend you discuss your options with your accountant, attorney and/or investment advisor to choose the savings vehicle that works best for you and your grandchild’s situation.
The names of the individuals in this article have been changed to protect their privacy.
This blog is published to provide you with general information only and is not intended to provide specific or comprehensive advice. Every effort has been made to report accurate information. With many recent changes in the tax law, however, Money Care, LLC encourages individuals to seek advice from competent professionals for the most up-to-date information personalized advice.