OCEAN CITY – Tuition costs are rising, interest rates on CDs and other savings vehicles are declining, and the stock market is still volatile. That’s a worrisome combination for parents who have money invested in accounts allocated toward college savings for their children. What’s a parent to do?
There are several options that may make this far more doable than you might think. Here are some pros and cons of each:
•529 Savings Plans: These investment programs, operated by states and some educational institutions, have a tax-advantaged feature that makes them one of the most popular options among parents. Your contributions potentially grow tax-deferred, and distributions can be withdrawn free of federal taxes as long as the funds are used to cover "qualified higher education expenses."
The 529 plans give parents control of the purse strings. As the custodian, you decide when to make withdrawals. You can even reclaim the funds, although any earnings portion of such nonqualified withdrawals is subject to income tax plus an additional 10% penalty. And assets can be transferred to another beneficiary without incurring a penalty, as long as that beneficiary is a qualified family member as defined by the Internal Revenue Service.
The potential downside for traditional 529 savings plans is the limitation on where you can invest your money. You are permitted to change how your existing assets are invested only once per calendar year or when you change the beneficiary.
Finally, as with most other investments, 529s are vulnerable to the market’s ups and downs. Therefore, you should monitor your account and make changes as necessary based on the age of your beneficiary, your risk tolerance and your time horizon for needing the funds to pay for college expenses. Fortunately, most 529 plans offer age-based investment strategies that automatically make such allocation changes for you.
•Coverdell Education Savings Accounts: Also known as education IRAs, Coverdell Education Savings Accounts offer tax advantages similar to those of 529 plans, but with more investment and spending flexibility. As the account holder, you can invest in any investment your financial institution offers, and the account balance has the potential to grow federal tax-free. What’s more, qualified withdrawals can be used for elementary and secondary school education expenses, as well as for college, and are federal tax-free. As with a 529 account, any earnings portion of nonqualified withdrawals is subject to ordinary income tax and may be subject to a 10% federal penalty.
UGMA/UTMA Custodial Accounts: Giving the Gift of Education
Though not college-specific, UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfers to Minors Act) custodial accounts are often used by parents or grandparents to save and invest for a child’s college expenses via gifting. A custodian (usually a parent) manages investments and distributions of funds in the account until the child reaches a specified age.
However, with a custodial account, only the first $950 of earnings in a given year is tax-exempt. The next $950 of annual earnings is taxed at the child’s tax rate. Unearned income above $1,900 is generally taxed at the parents’ tax rate if, at the end of the year, the child is under age 19 or is a full-time student under age 24.
Ultimately, whatever college planning option you choose, the most important step is to start saving soon — even in small, monthly amounts — to take advantage of compounding.
(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)