Developing an education funding plan early in a child’s life is critical as tuition inflation has typically fallen in the range of 5% – 8% per year. This high rate of tuition inflation may make paying for education more difficult if an effective education funding plan has not been employed. Families may consider paying education expenses as they are incurred or saving for expenses in advance of their occurrence. The benefits of saving for education include the reduction of overall out-of-pocket expenses (assuming investment growth over the relevant saving time period) and, depending on the savings vehicle used, measurable tax advantages. Some of the education savings vehicles to explore include:
Coverdale Education Savings Accounts
Qualifying U.S. Savings Bonds
2503(c) Minor’s Trusts
A 529 plan is a program that allows individuals to either prepay, or contribute to an account established for paying a student’s qualified education expenses at an eligible educational institution. 529 plans can be established and maintained by states (or agencies of a state) and eligible educational institutions. The program must meet certain requirements and only certain expenses are covered by the plans. Contributions to these plans grow tax free and distributions for qualified education expenses are free of tax.
A custodial account is a brokerage account established under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), and managed by an adult for the benefit of a minor. It is used to pass irrevocable gifts to a minor, or as a savings account for the minor. Earnings in these accounts are taxed at the minor’s income tax rate unless the earnings exceed a given threshold. Earnings over the income tax threshold are taxed at the guardian’s income tax rate. Once the minor reaches the age of majority (age 18, 21 or 25 depending on the state and the type of account used) the account is transferred into his/her name, individually.
Coverdell Education Savings Accounts
An Education Savings Account is a tax-advantaged investment account set up and managed by a parent or other adult for the benefit of a minor. It can be used to pay qualified education expenses for grades K–12 and for college. The total contributions to these accounts cannot exceed $2,000 in any year, no matter how many accounts have been established. Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed. The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution.
Qualifying U.S. Savings Bonds
The Education Savings Bond Program permits individuals to exclude from their gross income all or a portion of the interest earned on the redemption of eligible Series EE and Series I bonds issued after 1989, when the bond owner pays qualified higher education expenses in the same tax year as the bond redemption. In order to qualify for this tax break, the bond owner must have been at least 24 years old when the bond was purchased, must file jointly (if married) and must meet certain income requirements. In addition, the exclusion only applies to qualified education expenses incurred at eligible institutions.
2503(c) Minor’s Trust
A 2503(c) Minor’s Trust is a trust established for the purpose of holding gifts for a child until the child reaches age 21. Typically, gifts made to a 2503(c) Minor’s Trust are considered “gifts of a present interest” and therefore qualify for the annual gift tax exclusion. In order to qualify for this status, the trust must meet the following requirements:
- Principal and income in the trust may be used by or for the benefit of the minor before the child reaches age 21.
- If the minor dies prior to reaching age 21, the trust will be included in the child’s estate.
- All undistributed principal and income must be dispersed to the child on his/her 21st birthday.
- Gifts to the trust are irrevocable.
Any distributed income will be taxed at the minor’s income tax level and undistributed income will be taxed at the trust income tax level. For purposes of financial aid considerations, a 2503(c) Minor’s Trust is considered the property of the child and may have a negative impact on financial aid availability.
There are definite benefits for developing and executing an Education Funding Plan including:
- Potentially reducing the overall out-of-pocket expenses because of investment growth.
- Depending on the vehicle that is employed, there may be tax benefits from saving for college.
- Stabilizes cash flow by spreading out the cost of education over a number of years.
Given that certain education accounts have an infinite lifespan and are transferable, education funding can be an effective generational planning tool.
It is also worth considering the potential negatives including:
- The donor loses personal control over the gifted assets and all income associated with the assets (although the donor may retain custodial control over the assets).
- There is a risk that the child does not pursue higher education or that the account is over or under funded.
Depending on which method is used, there is the potential for complexity in the establishment and management of the savings account.
More tools and research for selecting college education savings vehicles may be found at http://www.savingforcollege.com.