You want your children or grandchildren to be successful. You want them to be self sufficient. You want them to have a good start in life and you think college is one way to do it.
But college is expensive. Public universities can be $20,000-$25,000 or more per year. Private colleges can be $40,000-$50,000 or more per year. The best time to think about college for your children or grandchildren is when they are born. It certainly is a lot easier to put away $100 to $200 per month starting when they are born than trying to put away $500 or more a month after they hit high school. How can you save for college? Well, there are a variety of ways. We will discuss a few of them in today’s column.
Personal savings. You could just set up a savings account in your own name and make regular deposits into that account. Any dividends or interest earned on the account would be reported on your Form 1040 U.S. Individual Income Tax Return. You pay income taxes on these earnings during your lifetime. When you need to pay for college, you just make withdrawals out of that personal account.
Custodial accounts. Another type of educational savings tool is a custodial account in which you actually give funds to your children or grandchildren. Since minors cannot legally own property, you hold it for him or her under either the uniforms gifts to minors act (UGMA) or uniform transfer to minors act (UTMA). You probably have seen these accounts before.
Each year, you can make a gift to each of your children or grandchildren up to the $13,000 annual gift tax exclusion without triggering a taxable gift. A married couple can make a gift to each of up to $26,000 per year. It is considered a gift when you deposit funds into the account, not when you take it out. These gifts are never subject to gift, estate or generation skipping transfer taxes.
These accounts are deemed property of your children or grandchildren, so they are taxed on the income earned. However, if the earnings are subject to the Kiddie Tax, there may not tax savings available since the earnings are taxed at the parents’ rate. Since it is the kids’ money, when they need it you can use it for them.
One down side of these UTMA or UGMA accounts is that once your children or grandchildren reach the age of majority, 18 or 21 in some instances, they miraculously gain all the wisdom and incite of adulthood and have full access to these accounts. You no longer are in control and they can use it anyway they please. They can have a wild weekend in Las Vegas or go to the University of Corvette, and use your gift to do it.
529 plans. You can set aside a certain sums of money in a qualified tuition program allowed by Section 529 of the Internal Revenue Code. Earnings on these 529 plans are not currently taxed and if the distributions are used for certain post-secondary education expenses, they are free from federal income tax and maybe free from state income tax.
There is a special rule for 529 plans that gives a multiplier effect to the annual gift tax exclusion. You can gift up to five times the annual exclusion amount in a given year or $65,000 per child or grandchild without triggering a taxable gift. A married couple could gift up to $130,000 each. If you take advantage of the multiplier effect, you cannot make any more taxable gifts to that child or grandchild for the next four years. If you die during the next four years, part of the gift is brought back into your taxable estate.
If the named beneficiary of the 529 plan does not go to college or does not use up the plan funds, the account may be able to be transferred to certain other relatives. You can also distribute the plan funds back to yourself by paying the income tax and a 10% penalty on the earnings distributed.
Life insurance. If you need life insurance on yourself and/or your spouse and you are going to purchase it anyways, you may be able to use a life insurance policy as a tax sheltered college savings tool. This is what my wife Emily and I used for our children. When our children were born, qualified tuition programs were not as financially attractive tools as they are today. We both needed life insurance so we purchased variable universal life insurance policies on each of us.
The premium payments made over and above the annual insurance costs were invested in a variety of mutual funds that were available within the life insurance policies. The earnings on those funds accumulated income tax free. When the kids started going to college, we made withdrawals as needed. Not until we withdrew all of our premiums paid over the years would there be any income tax effect.
Cloverdell education savings accounts (ESAs). Cloverdell ESAs are another type of tax advantaged educational account. Although I have never seen a Cloverdell ESA, I have read quite a bit about them.
Like other tax advantaged educational plans, Cloverdell ESAs allow the amounts to be withdrawn out of the account income tax free in they are used for qualifying educational expenses. Those funds can be used for kindergarten through 12th grade, whereas the educational expenses for 529 plans are for post-secondary expenses only. However, there are some limitations for Cloverdell ESA contributions. Contributions are limited to $2,000 per beneficiary per year.
It does not matter what type of college savings you do, just do something. If you start early when the kids are young, there is much less of a financial strain on the family when college time comes.
By Matthew M. Wallace, CPA, JD
Published edited November 20, 2011 in The Times Herald newspaper, Port Huron, Michigan as: Saving for college begins at birth