College Funding—How to Choose the Right Plan

Most people understand the value of a , but the to break the bank for a lot of families. With the cost of rising faster than inflation, parents of today's toddlers may face college costs higher than their total home mortgage. But if you start saving while they’re in pre-school, you'll put yourself in a good financial position by the time your son or daughter is ready to hit the dorm rooms.

Choosing the Right College Account

Choosing the right college savings plan can feel overwhelming. With at least a half dozen different types of college savings accounts, all with unique sets of complex rules, it's tough to even know where to start. In order to make the best decision, you’ll need to know a little about each option.

• 529 Plan:

The 529 Plan is considered one of the best options for saving for a child’s college education. They are called simply “529” plans after the specific IRS code that permits their use. There are two types of Section 529 plans—savings accounts and prepaid tuition plans.

The Section 529 Savings account allows for after-tax contributions to be made on behalf of a designated beneficiary (not just a child). Qualified withdrawals are free of federal tax and most plans let you save in excess of $200,000 per beneficiary. Plus, there are no income limitations or age restrictions, which means, you can start a 529 no matter how much you make or how old your beneficiary.

• Coverdell ESA:

The Coverdell ESA was originally introduced in 1997 as the Education IRA. In 2001, Congress expanded its benefits and renamed it the Coverdell Educational Savings Account (ESA). The account allows up to $2,000 per year in after-tax contributions to be made in a child’s name. These contributions grow tax-deferred and may be withdrawn tax-free for qualified educational expenses. But, if the money is not used by the time the child turns 30, it must be given to them or rolled over to a Coverdell ESA for another family member.

• Custodial Accounts (UGMA and UTMA):

Before 529 Savings plans and Coverdell ESA’s, parents were successfully using UGMA / UTMA accounts to accumulate significant amounts of money for their children’s college. The UGMA (Uniform Gift to Minor’s Act) and UTMA (Uniform Transfer to Minor’s Act) are nothing more than custodial accounts. A custodial account is used to hold and protect assets for a minor until they reach the age of majority (typically 18 or 21) in their state.

Aside from the requirement to hand over “control” of any remaining money to a child at 18 or 21, these accounts are extremely flexible. It’s basically up to the custodian (usually the parent) to determine how to invest the money and when to spend it on the child. But ultimately, the child has the power to control the money as the see fit.

Because the assets are considered the property of the minor, these accounts are often used to take advantage of the “kiddie tax.” The kiddie tax allows a certain amount of a minor’s income to go untaxed, and an equal amount to be taxed at the child’s tax rate (quite less than mom and dad’s tax rate).

• U.S. Savings Bonds for Education:

Purchasing US Savings Bonds (Series EE or I) is one of the simplest ways to set aside money for college. There is no need to open an account at a financial institution, complete complex paperwork, or research and manage investment options. Savings Bonds are considered an “accrual” type investment, which means that their value increases over time. Additionally, the future value of Savings Bonds, especially Series EE bonds, is very easy to estimate.

Series EE Bonds are purchased at half of their maturity value, and slowly increase towards that amount. Series I Bonds are purchased in denominations of $50 to $10,000, and slowly grow in value according to prevailing interest rates. The government, as an incentive to purchase Series EE and I bonds, allows the growth in value to be exempt from Federal and state taxation if cashed out and used to pay college expenses.

• Using IRA's for College Savings:

Perhaps the biggest potential advantage to using an IRA for college savings is that retirement plan assets are not included in most financial aid calculations. If an identical amount of money is saved in a Coverdell ESA or a 529 Savings plan account, 5.64% of its value will count against financial aid each year.

Another advantage is that unused funds, if held in the IRA until normal retirement age (at least 59 1/2), will not be subject to a 10% withdrawal penalty. In the case of a Roth IRA, they will not be subject to income tax, either. This stands in contrast to the 10% penalty (plus incomes taxes) levied against unused 529 or Coverdell ESA funds when they are withdrawn.

The biggest disadvantage to this strategy is the loss of the use of an IRA for your annual retirement savings. Using a retirement IRA to save for college eliminates your ability to use it to save for your future.

• Educational Trusts (Crummey Trust):

The Crummey Trust, named after the first family to set one up, allows parents to transfer large amounts of wealth into a tightly controlled trust. This trust account can be used for education, but is not limited to that purpose. Additionally, parents with a desire to utilize unconventional investments not permitted in 529 Savings plan accounts or Coverdell ESA's may do so in the Crummey Trust.

Crummey Trusts offer parents the highest amount of control of any account where a gift must be irrevocable. The money in the trust, and the parent’s control over it, can be used to motivate irresponsible children. To meet the IRS qualifications for Crummey Trusts, any gift made to the trust must be available for withdrawal by the child for a short period of time (typically 14-60 days). Usually this is not a problem, as the child can be convinced that they’ll never receive another gift if they take the funds.

One of the main advantages for parents is the generous age restrictions on these trusts. They can be set up so kids do not have access to the money until their late twenties or early thirties. Crummey trusts are subject to significant setup and upkeep costs, as well as higher levels of taxation. This generally makes them unattractive for the vast majority of families.

College is an investment for a lifetime—the gift of a college education can open the door to a world of opportunity for your child or grandchild. Saving, even a little at a time, can make a big difference down the road. With the cost of a college education continuing to increase, the key is to start saving early and regularly.