Do’s and Don’ts of College Planning
Graduation ceremonies abound this time of year. It is a reminder that college expenses are just around the corner.
18 years ago, parents might have begun saving for their child’s college costs with a Uniform Gift to Minors Act (UGMA) or a Uniform Transfer to Minors Act (UTMA). This is an account that is set up in the minor’s name. A parent may be the custodian on the account.
These were popular because the earnings were taxed at the child’s tax rate. Tax laws eventually changed and now the first $1,000 is tax exempt. The amount between $1,000 and $2,000 is taxed at the child’s rate. Amounts over $2,000 are taxed at the parent’s rate.
The amount you may accumulate in an UGMA is unlimited. However, the annual gift tax amount does apply which is currently at $14,000.
There aren’t any restrictions on how the money may be used. It can be used for travel costs to the college, off campus housing, clothing, medical insurance etc. Monies can also be used on behalf of the child prior to college such as private schooling and summer camps. However, basic needs of the child need to be paid by the parents or guardians.
Unlike some college savings programs, you can’t change the beneficiary on the account. The child, for whom you set the account up, is the one who needs to use ALL the assets. Ownership of the account is the student’s.
This has 2 drawbacks. If you apply for financial aid, the monies are counted as the child’s and 30% of the assets will be included in the family contribution. As the parent’s asset, only 10% of the assets is included.
The second drawback is the control of the assets transfers to the child at the age of majority, which may be 18 -21 depending on the state. At 18 years of age, a car can be much more appealing than a college education.
Fortunately, Congress has established other tax favored means of saving for college expenses.
We will explore those options in the next few weeks.
Educational Savings Accounts
Are college expenses looming on your horizon? Educational Savings Accounts are another option available to save for college costs.
This savings account is a nondeductible contribution limited to $2,000 per year, per child. The earnings on the contribution grows tax deferred and can be 100% tax free if used for qualified expenses. The $2,000 limit is from all sources, including grandparents.
Qualified college expenses include tuition and fees, books, supplies, equipment, and room and board if the student is attending at least half time. Educational Savings Accounts may also cover expenses for K-12.
Contributions may be made until the child reaches 18. And the monies must be used by the time the child/beneficiary reaches 30. However as the asset is the parents’, the beneficiary may be changed to another family member. This allows flexibility in planning for the child’s further education. Some children may choose other routes like military, or receive scholarships.
And since the asset is the parents, it is counted as such in the financial aid family contribution.
The money may only be withdrawn tax free if it is used for qualified expenses. If it is used for other purposes, the earnings are included in taxable income, and is subject to a 10% penalty. Be careful to not overfund.
A more commonly known college savings plan is the Qualified Tuition Program or 529 plans. What is less well known is there are 2 types of this plan under this program.
A lesser known program is the prepaid tuition plan. Prepaid tuition plans allow you to buy future tuition at today’s prices. With 6% inflation per year in college costs, locking in a price has some advantages. The drawback is, knowing which college your child will want to attend. Once you fund at a college, you are locked in – very few exceptions for refunds.
The more recognized 529 plans act similarly to the educational savings plan. The contributions are not deductible. But the earnings grow tax free. The monies are withdrawn tax free if they are used for qualified college expenses and ONLY for college expenses. If they are used for other purposes, the gains on the funds are included in taxable income and subject to a 10% penalty.
The amount you may fund is limited to the $14,000 annual gift tax exclusion. Unless you select the 5 year election, then your maximum is $70,000. The collective maximum you invest is determined by the program and may be as much as $300,000 per beneficiary.
Nearly every mutual fund family has a 529 program. However, your state may have a specific plan. For example, Idaho has the Ideal plan. If you contribute under this program, you may deduct up to $8,000 per year on your Idaho income tax return. You are restricted to the investment choices of the program.