There are several types of accounts used to invest for a child’s education. Account ownership and tax-advantages should be considered when choosing which college investment account is right for your situation.
Parent Owned Account
You may establish an investment account in your own name. This approach provides maximum control over how the assets are used. If your child does not go to college, the parent may use the account for any purpose. The downside is taxation, which is at the parent’s rate, not the child’s rate.
Custodial Accounts (UGMA/UTMA)
An adult can establish a "custodial" account in the name of a minor. This is an irrevocable gift and will shift to the child’s control at age of majority, which varies by State. In most cases, gains are taxed at the child's tax rate. Colleges will consider a higher percentage of money held in custodial account than in a parent owned account when making financial aid eligibility decisions.
These tax-advantaged plans allow the adult to control the account on behalf of the child. Unlike the UGMA/UTMA, the beneficiary may be changed to another member of the beneficiary’s family. There are generally no time or age restrictions on the use of the money.
Contribution limits are high, deductible on most state tax returns, grow tax-deferred and may be withdrawn tax-free. Specifics for these plans vary by state.
There are two types of plans, College Savings Plans and Prepaid Tuition Plans. Because plans are established by each state, investment options, account features and state tax deductibility rules are different.
College Savings Plans
These plans give you more control than Prepaid Tuition Plans, but there is no guarantee your investment will be enough to pay tuition costs. You determine how much to invest, which investment option is best for you and you may spend the plan at any qualified institution of higher learning. Most College Savings Plans offer asset allocation portfolios matched to the child’s age. These age-based portfolios automatically rebalance to reduce risk as the child nears college age.
Prepaid Tuition Plans
In these plans you prepay all or part of tuition costs in today’s dollars and are protected against tuition increases. This plan is beneficial when tuition increases faster than your investment portfolio, but is not best when investment returns out pace tuition increases. These plans may or may not permit you to use the assets for colleges located outside of the state managing the plan.
Education IRA -- 529 Plan
An Education IRA is designed specifically for funding higher education costs. Also referred to as a 529 Plan, these state-sponsored college savings plans allow you to make contributions into an account to pay those future costs. 529 Plans offer tax advantages to both the account owner and the beneficiary since no income taxes are paid on the earnings if the money is withdrawn for qualified educational expenses.
Contributions can be made annually for each child younger than 18. The non-deductible contributions won't be subject to a gift tax, and the accounts will be tax exempt. Distributions that don't exceed amounts spent on education will be tax free, but all or part of the excess not spent on education may be subject to taxes and penalties. Consult with a tax advisor to determine if a 529 Plan is right for you.
Coverdell Education Savings Account (ESA)
These plans work like Roth IRAs. Contributions are non-deductible and your investment grows tax-free. Like 529 plans, the beneficiary may be changed to another family member, or the beneficiary must withdraw the funds by age 30 to avoid penalties. Funds can be used for the child’s educational expenses from grade school to graduate school.
Before investing in an Education IRA, check with your personal financial advisor or tax advisor to examine current rules and how they affect you.
A trust account can stipulate exactly how and when a recipient is to spend the funds. However, trusts can be costly to establish, may require an attorney and may disqualify your child from receiving financial aid.