In looking at the problem of saving for college, let’s define the magnitude of the problem. The current expenses, on average for 2016 are $42,224 for a 4-year private and $21,447 for a 4-year public in-state college (as estimated using the College Cost Calculator from the College Board). The problem compounds if we look at future costs of today’s estimated over $100,000 and $50,000 respectively per year if your child is born in 2017. Concurrent to those expenses we have competing interests for your money, such as: current lifestyle, taking care of children and potentially taking care of aging family.
There are several ways to save for college. The main differences are: 1) when and for what the money can be used, 2) the tax treatment of the money both before and during college, 3) who controls the money, and 4) how much can be saved in an account.
The basic account types for college saving are: Coverdell Education Savings accounts, Uniform Gift to Minor or Transfer to Minor accounts (UGMA/UTMA), Traditional taxable accounts and 529 College savings plans. For the purposes of this article, I will not look at life insurance or prepaid tuition plans.
A Coverdell Education Savings Account (ESA) can be used to pay qualified elementary, secondary or higher education expenses for a beneficiary. The distributions are tax-free if used for qualified education expenses. Contributions must be made in general for the beneficiary before they reach age 18. The total contribution must not exceed $2000 for any given year. Special attention should be considered regarding income limitations. An individual with a Modified Adjusted Gross Income (MAGI) less than $110,00 can contribute to the plan and a reduction in contributions with MAGI between $95,000-$110,000, For couples filing a joint return the numbers are $220,000 and a reduction between $190,000-$220,000. Corporations and trusts or other similar organizations may make contributions with no income restrictions. In general, the money must be distributed for the beneficiary by the time the beneficiary reaches age 30, or transferred to another beneficiary younger than 30.
Uniform Gift to Minors or Uniform Transfer to Minors accounts (UGMA or UTMA) are accounts created to be used to benefit the minor. In Colorado the minor takes control of the assets at the age of 21. Prior to that the account is managed by a custodian for the child, usually a parent. Assets held for the child can be wide ranging.
Traditional taxable accounts are usually held in the name of the parent or responsible party. Any taxable consequence in the account (losses, gains, interest…) are accounted for on the parent’s tax return. This structure becomes inefficient in the sense of retaining earnings for the child the higher the parent’s income tax bracket becomes. A benefit of this structure though is that the parent retains control of the asset. Thus, if the child chooses not to go to college, or the money is needed for other purposes, the parent has the flexibility to make decisions. A subset of this type of account would be the use of a trust. Again, the benefit exists that the assets remain in control of, in this case the trustee, of the trust instead of the child. But the assets will be taxable at Trust tax rates which increase even more rapidly than individual tax rates.
The Colorado 529 College savings plans allow for a tax deduction for Colorado residents. The control of the account remains with the account owner, usually the parent. Money can be used for college, graduate or vocational school. There is no time limit as to how long the money needs to remain in the account before it is disbursed for qualified educational expense. Both the principle and any growth are tax-free if the money is used for a qualified educational expense. Accounts can be set up by individuals or may be available at reduced expenses as part of an employer’s benefit package. Contributions to a plan are limited by gift tax rules. Currently $14,000 per year per donor. Both parents can contribute for a beneficiary making the amount $28,000. 529 plans do have a special provision providing for the acceleration of gifting such that 5 years of gifting can be put in the account in a lump sum, currently $140,000 for 2 parents gifting to a single beneficiary.