Guest blog post by Kristi Sullivan, Certified Financial Planner
As a financial planner who looks at a family’s whole money picture, I unfortunately have to tell most parents that they can’t even consider saving for college because they are so behind on retirement savings.
However, if you are on track for retirement, have an emergency fund, and aren’t carrying credit card debt, you are able to put some money away for your children’s’ college education. Then the question becomes, “How do I save?” There are three main ways.
529 College Savings Accounts are offered by each state. Contributions may be deductible on your state income tax return but not on the federal return. Contribution limits vary by state, but in Colorado the limit is a maximum of $400,000 across all three 529 plan options for the same beneficiary.
In 2018, you can gift a maximum of $15,000/year to as many individuals as you like without having to pay federal gift taxes. 529s allow you to front-load the gift for five years all at once. In other words, you can give as many grandchildren as you have $75,000 in a 529 account in 2018, but then you are done contributing for five years. A married couple can give $150,000.
The big advantage of 529 accounts is that all investment growth is tax-free, as long as you use the money for education expenses. This can include college tuition, room and board, fees, and laptops. As of 2018, you can use 529 money for K-12 private school tuition as well.
If you don’t use the 529 money for education, the growth (not principal) in the account is subject to income taxes and a 10% IRS penalty. If the original beneficiary doesn’t need the 529 money, the account can be transferred to any relative of the original beneficiary out to first cousins. That includes you, the parents, or hanging onto the account until your child has children and using it for them. Imagine all those years of compounding tax-free growth!
Investments are set pools of mutual funds chosen by the 529 provider and approved by the state. You don’t get to pick your own stock or mutual fund portfolio, and returns are not guaranteed. 529 accounts must be funded with cash and cannot accept appreciated securities. They are less damaging to the financial aid calculation, as the child (beneficiary) is not the owner of the account. On the other hand…
Uniform Transfer to Minor Accounts (also called UTMA or Custodial accounts) have been around for much longer than 529s. There is no tax benefit for contributions, and you’ll want to watch those $15,000/year gift tax limitations. There is no five-year front loading ability with UTMAs.
Up to about $2,000/year in dividends and capital gains would be taxed at the child’s rate. Any amount over that would be taxed at the parents’ rate. Contributions are an irrevocable gift to the child and should be turned over to that child at age 21 (or 24 if still a student). UTMAs are also considered the child’s asset when applying for financial aid, which lowers the aid for which a student may qualify.
There are some benefits to UTMAs that 529s don’t offer. You can use the money for any benefit of the child (summer camp, medical expenses, buying a car, wedding costs, a pony). Also, UTMA accounts can receive stocks or mutual funds, so if you are looking to move highly appreciated investments from your accounts without paying capital gains, this is a way to do it.
If you don’t like all the rules and restrictions of 529s and UTMA accounts, you can always open a regular taxable brokerage account in your name. The money can be mentally earmarked for college, but in the end, you can use it to buy a pontoon boat if your kids don’t end up going to college. There is no tax benefit to these accounts, but there are also no limits on how much you can put in, how it gets invested, or when and why you take the money out.
Another, less common option people consider is opening a Roth IRA with the intention of using it for college savings. Roths offer tax-free growth, but there are income limitations on who can use them. Also, you can only put $5,500/year away ($6,500 if you are aged 50 plus). Again, you have some pesky IRS rules to consider, but the benefit is that if you don’t use the money for college, you can use it for retirement instead.
I hope this primer on college savings options was helpful. Fidelity has a handy chart comparing different college savings choices. Also, College Invest is a great resource for all things related to Colorado 529 plans.
Kristi Sullivan is a Certified Financial Planner™ designee with over 20 years of experience in financial planning. She is the owner of Sullivan Financial Planning, LLC and offers advice, charging by the hour or project with no product sales. To learn more, visit her website.