Many of us Millennials are at that point in our lives where we’re starting to settle down. “I’m adulting real hard,” you’ve probably heard. You buy a house, you get married, you have kids…etc. Maybe not necessarily in that order, but you get the point, things only get more complicated.
When it comes to the financial planning process, this often involves discussions around kids and investing for college. Let’s face it, college is expensive. It’s a fact many of us Millennials are all too familiar with. Our generation has been particularly burdened by the sky-high cost of college and the oftentimes crippling debt that comes along with it. None of us hope to pass that burden onto our children. “But what options are available to me and which one really makes the most sense for me?”
There are a few different options out there with the two main ones being Coverdell Education Savings Accounts and 529 College Savings Plans. Many people also choose to use Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) custodial accounts and provide funds directly to their children. When it comes to choosing between these options, there are a few things you should consider about each of these methods. All provide tax advantages but can vary greatly in income restrictions on the contributor, contribution limits, investment options, distribution restrictions, and ownership. Let’s take a look at the options for investing for college.
Coverdell Education Savings Account
- Tax advantages: contributions are made with after-tax dollars, but account grows tax-free and distributions are tax-free as long as funds are used for education expenses only.
- Income restrictions on contributor as per 2017 IRS Guidelines: modified adjusted gross income (MAGI) must be less than $110k/yr if filing status is single, $220k/yr if filing jointly.
- Total contribution limit per year: $2,000.
- Investment options: very flexible and can reallocate portfolio as often as desired, similar to an IRA.
- Distribution restrictions: funds must only be used for education expenses, which can include preschool all the way through college.
- Ownership: once the child turns 18, they become the sole owner and can do whatever they want with the account once ownership is assumed including withdrawing the funds and paying penalties if not used for education expenses (10% penalty plus income tax on proceeds).
529 College Savings Plan
- Tax advantages: same as Coverdell – contributions are made with after-tax dollars, the account grows tax-free, and distributions are tax-free if used only for education expenses. Many states also offer partial to full tax-deductions to residents contributing to their state’s 529.
- Income restrictions on contributor as per 2018 IRS Guidelines: none.
- Total contribution limit per year: varies state by state, but typically anywhere from $100k to $350k per year. (Here in Washington State, a state-specific 529 plan is currently in the process of being designed and rolled out. Expected to be available by early 2018. We also have the GET program, expected to reopen November 1st, 2017. For more information, click here.).
- Investment options: typically much more restricted, confined to target date or style models created by the 529 providers and can only rebalance twice per year.
- Distribution restrictions: Can be used for secondary education and K-12 schooling since the recent tax bill was passed.
- Ownership: the parent is the primary account holder and retains ownership throughout the account’s entire life. If funds are not used for educational purposes, the account can be liquidated at 10% penalty plus ordinary income tax. Beneficiaries may be changed without penalty. Often times the first child will be assigned as beneficiary when he/she graduates and has leftover money if any, the beneficiary of the account can be changed to the next sibling.
UGMA/UTMA Custodial Accounts
- Tax advantages: income on assets gifted to child through UGMA/UTMA is taxed at the child’s tax rate and the assets avoid the estate tax.
- Income restrictions on contributor as per 2017 IRS Guidelines: none.
- Total contribution limit per year: none.
- Investment options: no restrictions..
- Distribution restrictions: none, the custodian can sell the assets for the child’s benefit at any time and for any reason, and the child can sell the assets at any time and for any reason, once they reach either 18 or 21, depending on which state they live in.
- Ownership: assets given are always owned by the child, but they do not have full control until adulthood. However, since the child is the owner, it can negatively impact their ability to receive financial aid in the future.
So which option is best?
That’s not an easy question to answer. However, in recent years, 529’s most often fit the bill, especially for parents who worry about what the child may do with the assets if they were to have unrestricted access to the funds. 529’s avoid this by allowing the parent to permanently retain control of the funds and be able to take those funds back for their own purposes (after paying 10% penalty plus ordinary income tax of course) if the child does not go to college.
Coverdells are great in that they can be used for all educational purposes, but they have very low annual contribution limits as well as income restrictions on the contributor. The low contribution limits make it nearly impossible to fund four years worth of college expenses at today’s cost.
UGMA/UTMA’s are less favorable for designating money solely for education expenses, but they do allow the funds to be used for any purpose. It also gives up control of the funds when the child reaches the age of majority (21) and can be disastrous if they aren’t necessarily prepared to handle a large sum of money.
When deciding which option makes the most sense for you, you need to understand what your specific goals are for the funds. Are they to pay for college? Are they to pay for private high school? Or do you simply want to gift your child money for the sake of paying lower taxes on a portion of your income? You then need to take into consideration all the pros and cons of each, and how those align with your own needs and goals. One thing is for certain, investing for college early and often for a child, will help ease the burden of debt or reduce the amount you’ll have to pay upfront when the time comes.
If you need assistance determining which option fits your situation best, schedule a free consultation with us today.