There are several alternatives to paying for college education. In one of the most popular scenarios, a family pays out of pocket from disposable income and if necessary, obtains loans from any governmental sources or possibly from a private resource such a home equity loan on a primary residence.
If the child is young enough, it may be more advisable to start saving money in a better type of savings plan such as a so-called Section 529 Plan or an Education Savings Account (ESA.) There are benefits and detriments of each type of plan, so you must make an intelligent decision about your selection based on family circumstances.
A Section 529 Plan allows funds to be deposited into an account, and so long as the funds are used for education, any income or growth earned on the account is withdrawn tax free. A further benefit is that the beneficiary of the plan may be changed if the initial beneficiary elects not to attend college or perhaps obtains a full scholarship and doesn’t need the money. A substitute beneficiary may be named who may utilize the funds for his or her education.
There are, however, some disadvantages. If the funds are not used for education, then there is a 10% penalty and income taxes will be assessed on the funds that are withdrawn that otherwise would have been withdrawn tax free.
Also, in the 529 plan, the selection of investment vehicles may be limited, as most states have elected only one investment source for the funds, so if a particular investment company is desired, a plan must be obtained within that particular specific advisor.
Also, the transfer of the funds within the 529 plan are limited. There is basically no limit on the amount that can be put in a 529 plan, as a parent may fund the plan as well as a grandparent. Since the gift exclusion on an annual amount is $13,000.00 per year, a significant amount of money may be placed in the 529 plan at any time.
Alternatively, with the ESA, contributions for beneficiaries are subject to a maximum dollar amount, currently $2,000.00 for 2012. This amount is also proposed to be reduced in 2013 and later years at the rate of $500.00. In addition, the ESA contribution is phased out as the donor’s modified adjusted gross income rises. When the single individual has income of $95,000.00 to $110,000.00, the contribution is basically phased out. For married individuals, the limits are $190,000.00 to $220,000.00.
However, these limitations do not apply to 529 plans. Also, in an ESA, in order to maintain the tax advantage, all distributions and funds must be distributed by the age of 30. This is also not the case with a 529 plan, as funds may be continued to be held in the plan for children, grandchildren, or any other beneficiary.
Another choice is to merely have funds placed in a Uniform Transfers to Minors Act Account. In this situation, the funds earn interest, which is taxable and payable at the rate of the child. Subject to the limitations and restrictions of the so-called “kiddie tax,” the funds may have income tax consequences, but the funds are withdrawn after taxes when used for education, since they have already been income taxed. However, based on the particular state law, the Uniform Transfers to Minors Act Account must be withdrawn by the age of 18 or 21, thus the child has unlimited access to the funds at that particular time.
How college savings are held may also affect the child’s ability to obtain financial aid. All of the aforementioned techniques may have a detrimental affect on the ability to obtain aid, but if the funds are available within a family, strong consideration should be made to prefund the education as opposed to relying on financial aid or private funding.
Hyman G. Darling, Esq.
Photo credit: Microsoft