As you begin your search for tax-efficient strategies to pay for college costs, keep in mind that 529 plans, Coverdell Education Savings Accounts, and UGMA/UTMA accounts each offer unique benefits. It’s critical that you understand all of them before making a final decision.
Section 529 college savings plans are named after the section of IRS code that created them. They are college- or state-sponsored, tax-advantaged plans that allow individuals to invest in portfolios of stocks, bonds, and cash equivalents. Contribution limits for 529 plans vary from state to state. Distributions made to pay qualified education expenses are tax free. Prepaid tuition plans also fall under Section 529, but for the purposes of this article, the phrase 529 plan refers only to a college savings plan.
Coverdell Education Savings Accounts (formerly known as Education IRAs) allow tax-free earnings on nondeductible contributions of up to $2,000 per year, per student. Coverdells can generally hold a variety of investments. They can only be established for a child younger than 18, and the money must be distributed for educational costs before the beneficiary turns 30. Income limits apply: Single filers with modified adjusted gross incomes (MAGI) of more than $110,000 and joint filers with MAGI in excess of $220,000 are not eligible. Qualified withdrawals may be used to fund a primary, secondary, or college education.
An UGMA/UTMA custodial account allows you to establish a savings or investment account in a child’s name, with one adult named as custodian. Each parent can contribute up to $14,000 in 2016 without triggering mandatory filing of IRS Gift Tax Form 706 and possible payment of gift taxes. With an UGMA/UTMA account, the first $1,050 per year of unearned income is tax free. For children under 19 (and for children under 24 who are full-time students and whose earned income does not exceed half of the annual expenses for their support), the next $1,050 is taxed at the child’s rate. Beyond $2,100, the income is taxed at the parent’s or child’s rate, whichever is higher.