Since their introduction in 1996, 529 savings plans have proven to be a popular way to save for college, accumulating more than $110 billion in assets. Learn more about 529 plans here.
Although a 529 plan may be a good choice for many individuals and families, be sure to consider some alternatives when developing a college savings strategy.
529 Plan Alternatives
A Coverdell education savings account (ESA, formerly called an education IRA), offers the same tax deferral and tax-free distribution advantages of a 529 account.
Pluses:
- You may also use a Coverdell ESA to cover qualified elementary and secondary school expenses.
- You can transfer the account to another eligible beneficiary if your child decides not to go to college.
- You have a much broader range of investments available to you than you would with a 529 plan.
Minuses:
- There is an annual contribution limit of just $2,000 for any one beneficiary. That may not be enough to accumulate a sufficient college fund.
- You must meet income eligibility limits to be able to contribute to a Coverdell ESA. Currently, your modified adjusted gross income must be less than $110,000 (single filer) or $220,000 (joint filers) to be eligible to contribute.
Custodial accounts, like a Uniform Transfer to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) account, can be used for any expense benefitting a minor, including education.
Pluses:
- You can gift up to $13,000 ($26,000 if your spouse joins you in the gift) in 2011* without triggering estate taxes.
- Up to $950 in annual unearned income may be tax free, and the next $950 taxed at the child's presumably lower rate, for dependent children under age 19 (age 24 for dependent students).
Minuses:
- Once the child reaches the age of majority (18 in California, unless the account specifically mentions a later age, up to 21), the account is his or hers without limitation on how it can be spent.
- Because financial aid formulas generally target a greater percentage of a child's assets than the parents', an UTMA or UGMA may negatively affect eligibility for financial aid.
You can save on your own through a taxable account.
Pluses:
- Complete freedom to choose the investments you wish, and the account belongs to you with no strings attached.
- There are no income restrictions and no restrictions on the age or relationship of the beneficiary.
- Parents' personal savings generally do not have as large an impact on a child's financial aid eligibility, since most formulas consider only about 5% of the parents' assets available for education costs, compared with about 20% of the child's assets.
Minuses:
- There are no education tax breaks. You will pay taxes on any earnings in the account. However, if you have long-term capital gains, earnings will be subject to the more favorable long-term capital gains rate instead of ordinary income taxes.
A Big Step
College costs will likely rank second only to a home purchase in major lifetime expenses, so it pays to consider all your options.
* Note: Annual exclusion is indexed to inflation and may be adjusted in future years. Note that the maximum federal estate tax in 2011 is 35%, with an applicable exclusion of $5 million.
Note that California Teachers Association does not give tax or legal advice. Consult your tax advisor or attorney for information specific to your situation.