Coverdell Education Savings Plan (ESA) – Families with $110,000 in income for a single individual or $220,000 for a married couple are eligible to establish a Coverdell ESA. Contributions are limited to $2,000 per year, but Coverdell ESA’s can be set up by more than one person. That $2,000 will be magnified if more than one individual contributes to a Coverdell for an individual student. Contributions are not tax-deductible, but distributions from the ESA are tax-free as long as they are used for qualifying educational expenses. Coverdell ESAs can be used for elementary and secondary expenses, along with college and university expenses. All funds must be disbursed before the recipient reaches the age of 30
Uniform Transfer to Minors Act (UTMA) and the Uniform Gifts to Minors Act (UGMA) – The major difference between a UTMA and a UGMA is the type of financial asset with which you can fund them. The UGMA can only be funded with cash, securities, and insurance. The UTMA adds real estate and alternative investments. These accounts are irrevocable trusts. They are the property of the minor children upon deposit and are transferred to them when they become of age. For parents, there may be some tax advantages. Capital gains and dividend income are taxed at the minor child’s tax rate. Since this is usually lower than the parent’s tax rate, this is advantageous. Then, the first $1,100 of unearned income is tax-free. The second $1,100 is taxed at the child’s marginal tax rate. Beyond that, any unearned income is taxed at the estate tax level of 37%. Withdrawals are not taxed since contributions were made with after-tax money. These custodial accounts have often been used to safeguard money so it can be used for educational expenses and not wasted.
Mutual Funds – Mutual funds are not usually the preferred way to set up a college fund for baby. One of the main reasons is that the income generated by mutual funds is taxable. At the end of each year, many mutual funds make capital gains distributions to the investors. In addition, when you cash in the fund to make the money available for educational expenses, the appreciation is taxable income. Capital gains income will show up on the parent’s tax returns. 529 College Plans are a much better vehicle to use to save for your child’s education since they are tax-advantaged. Even the expenses associated with 529 plans are not enough to make mutual fund investment preferable. There are tax-managed mutual funds, but in that case, investments are chosen because of their tax treatment. In 529 plans, investments are chosen based on their merit.
Roth IRAs – Many parents consider using a Roth IRA as a college fund for baby. In most cases, a 529 plan may be a better choice. You can’t make withdrawals from the Roth IRA without a 10% penalty unless you are 59.5. However, if you haven’t had the Roth IRA for at least five years, you will pay the penalty anyway. Even if you can make withdrawals without a penalty, you will be taxed on the earnings from the investments in the IRA. You aren’t taxed on the contributions. If you use a 529 plan, you aren’t taxed on either income or contributions and you can contribute much more than the yearly maximum allowed for the Roth IRA. The distributions from a Roth IRA will affect student financial aid, but the 529 plan distributions will not.
Savings Bonds – Federal savings bonds have been used for decades to fund college educations. The Savings Bond Education Tax Exclusion allows you to avoid taxes on savings bonds if you cash them in during the same year as the educational expenses occur. You must also file a joint tax return if you are married, meet some income requirements, and go to a school that is eligible for federal assistance. As long as you purchase the savings bonds in your name, their impact is minimal on financial aid. Any savings bonds that are purchased for educational expenses should be Series EE or I. Savings bonds can be a good supplemental source of money for college to a 529 plan, for example.