Figure out Your College Savings Options

September 16, 2008
Thomas W. Batterman

Physician's Money Digest, May 31 2003, Volume 10, Issue 10

By now, you're probably well aware of the rising cost of college tuition. You may not be as familiar with how to save for this expense. When you're trying to save money to fund your children's college education, there are 3 primary ways to go about it. Following is a brief description of these 3 alternatives:

• 529 plan. These plans, which are offered by the state, arise out of Section 529 of the Internal Revenue Code. With a 529 plan, you make contributions to an account for the benefit of your child. These contributions are not deductible for federal income tax purposes, but there may be some limited deductibility for state income tax purposes. Gift tax rules and a requirement to file a gift tax return, if not pay a gift tax, may apply to contributions that exceed the gift tax annual exclusion (currently $11,000 per year).

Investments are limited to the investment options offered by the plan provider. Earnings grow tax deferred, and if money is withdrawn for qualified educational expenses, the earnings are tax-free. If your child does not go on to college, you can designate the account for another member of your family for educational expenses. If the money is withdrawn for noneducational expenses, all the earnings are subject to tax, plus a penalty tax of at least 10% on the earnings.

For parents with children who won't be attending college for a number of years, there are risks involved. The current 529 provisions expire by law on December 31, 2010. Since the law will have to be addressed at least by that time, there is a risk that the current provisions will be changed in the process. If your child will be attending school after 2010, you need to consider this risk. Also, while earnings on the investments in a 529 plan are tax-deferred, losses do not offer a tax benefit.

• Uniform Transfer to Minors Act (UTMA) account. This account allows you to give up to $11,000 per year to each child while they are young. Since they are not old enough to establish investment accounts themselves, these assets need to be set up in a custodial or UTMA account. Normally the parent is the custodian and controls the account. Parental control legally terminates at age 18. Investment options are unlimited, so parents can choose any investment vehicle they wish to invest in the UTMA account.

Current income tax is owed on the earnings in a UTMA account. Earnings are taxed to the child, and any investment losses provide an offset against such tax. For children under age 14, there is a "kiddie tax." Even though the income is taxed to the child, it is taxed at the parents' income tax rate. Children ages 14 and older pay taxes on any income they receive, at the regular rate applicable to their level of income.

• Parental funds. Some parents simply save money for college in an account in their name. Earnings on such investments are taxed to parents as part of their income, but the parents are also able to benefit from any investment losses that may be incurred. When the child goes to college, the parents may give the child up to $11,000 per year toward expenses without any gift tax issues; much more can be given if necessary without a gift tax, although preparation of a gift tax return might be required.

If the child decides not to go to college or if the parent doesn't think the child is behaving responsibly in pursuit of educational goals, they can elect to keep their money. The parents can then choose to invest these set-aside dollars in any way they desire—parents' investment options are unlimited.

How you choose to save for your child's college education is most often not nearly as important as the fact that you're saving something. Sometimes parents get too wound up worrying about the tax attributes and lose sight of important non-tax considerations. Unless you're making well over $200,000 annually and you intend to provide at least $75,000 toward your child's college expenses, the actual difference in tax dollars paid between these 3 alternatives is a few hundred dollars if you start saving early.

If you will be giving more than $75,000 per child, you're at a level where an irrevocable trust may be warranted from both a tax and a non-tax perspective. More substantial college savings should really be accorded full, formal, and professional treatment through a trust rather than using 1 of the 3 options discussed, which are really more "mass market" college savings solutions.

However, if your funding desires are less than $75,000 per child, it is much more important that you consider how you're going to address funding for a child who doesn't go to college or who is irresponsible and can't be trusted with the money, than it is to save a couple of dollars in taxes. As with any financial decision, it is in your best interest to seek the professional guidance of an objective, impartial advisor in selecting the college savings option that is best for you.

Thomas W. Batterman is president of the Association of Independent Trust Companies, a national organization of more than 100 chartered, well-capitalized, and insured members who manage their clients' financial assets during life and after death. For more information, visit