Let’s highlight the major college savings mechanisms used today and how each of them compare/differ.
1) 529 Savings plan:
- Taxation of earnings: Tax-exempt when used for qualified higher education expenses.
- Income limits: None.
- Control of assets: Account owner retains control of assets and can choose to change the account beneficiary or revoke the assets through a nonqualified withdrawal.
- Ability to change beneficiaries: Can be changed but, in order to prevent a nonqualified distribution, the new beneficiary must be a qualified family member of the current beneficiary.
- Revocability of assets: Assets are revocable. See nonqualified withdrawal penalty below.
- Penalty for nonqualified withdrawals: Earnings withdrawn are subject to federal and state income tax along with a 10% federal penalty. Note: To avoid nonqualified withdrawals, funds in 529 plans that have been in place for 15 years or more can now be used to contribute to a Roth IRA (subject to annual contribution limits) in the beneficiaries name up to a maximum of $35,000 over the lifetime of the beneficiary.
- Estate planning benefits: Account assets are removed from account owner’s taxable estate.
- Impact on federal needs-based student aid: Plans owned by a student or parent are treated as parental assets, which are assessed at a maximum of 5.64% in the financial aid formula.
- Federal gift tax treatment: Qualifies for annual gift tax exclusion or front-loaded gift tax exclusion of up to 5 years.
2) UTMA/UGMA:
- Taxation of earnings: Taxable each year.
- Income limits: None.
- Control of assets: Custodian, often parent or other guardian, acts as a fiduciary on the beneficiary’s behalf until the age of majority, usually 18 or 21 depending on the state of residency.
- Ability to change beneficiaries: No.
- Revocability of assets: Assets are irrevocable. You cannot take them back! A transfer to an UTMA is a gift in the year you make it.
- Penalty for nonqualified withdrawals: Not applicable.
- Estate planning benefits: Assets are removed from donor’s estate if the donor does not act as custodian.
- Impact on federal needs-based student aid: Assets are the student’s (where student is the beneficiary); assessed at 20%.
- Federal gift tax treatment: Qualifies for annual gift tax exclusion.
3) Non-qualified investment account:
- Taxation of earnings: Taxable each year.
- Income limits: None.
- Control of assets: Account owner controls assets.
- Ability to change beneficiaries: Not applicable here. The choice is always the account owner’s regarding who they decide to designate as beneficiary.
- Revocability of assets: Account owner has discretion over assets.
- Penalty for nonqualified withdrawals: Not applicable.
- Estate planning benefits: None.
- Impact on federal needs-based student aid: Assets are in the parent’s name and assessed at a maximum of 5.64% in the financial aid formula.
- Federal gift tax treatment: Qualifies for annual gift tax exclusion.
4) Roth IRA:
- Taxation of earnings: Withdrawals of earnings before age 59.5 that ARE used for higher education expenses are subject to federal and state income tax but NO 10% penalty. Earnings after age 59.5 are tax-free.
- Income limits: Subject to annual IRS Modified Adjusted Gross Income (MAGI) limits.
- Control of assets: Account owner controls assets.
- Ability to change beneficiaries: Not applicable here. The choice is always the account owner’s regarding who they decide to designate as beneficiary.
- Revocability of assets: Account owner has discretion over assets.
- Penalty for nonqualified withdrawals: If account owner is not at least age 59.5 and the withdrawal is not used for higher education, earnings are subject to federal and state income tax along with a 10% penalty.
- Estate planning benefits: None.
- Impact on federal needs-based student aid: Is not counted as an asset of the parent or student. But Roth IRA withdrawals are counted as income even if they are not subject to income tax.
- Federal gift tax treatment: Qualifies for annual gift tax exclusion.
That’s a high-level summary of the most popular college funding mechanisms today. There are other options such as prepaid tuition plans, savings bonds, or Coverdell accounts, but they aren’t as popular, so I figured I’d just touch on the major ones. As seen here, each account has different pros and cons and the right college savings plan for one person may be completely different than the next. Often a hybrid approach works best where multiple accounts are used to fund higher education goals.
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