My best advice when it comes to saving for education costs: Save for yourself first.
Put money into college savings only if you have a handle on your own retirement. Grandkids and kids will be able to work and take out student loans to pay for college. But you cannot borrow money to pay for retirement.
For younger parents who insist on trying to do both, I suggest considering a Roth IRA.
The Roth IRA is a tax-advantaged retirement account that lets you withdraw contributions (after five years) for a variety of circumstances, including qualified education expenses.
It’s like killing two birds with one stone. Of course, if you do take from your Roth IRA for school expenses, you are reducing your retirement fund.
Otherwise – once your retirement fund is in order – you need to know about the options available for tucking away money for school. A few options offer tax advantages.
Coverdell Education Savings Account
Formerly called the Education IRA, the Coverdell allows tax-qualified withdrawals for certain education expenses at the elementary- and secondary school levels as well as for higher education.
Contributions are not allowed for a beneficiary over 18, so Coverdells make sense for parents saving for private elementary school or private high school.
A Coverdell must be used before the beneficiary is 30 years old, but the account owner has the option of replacing the beneficiary with a family member still under age 30.
Because the total contribution for any beneficiary is capped at $2,000 per calendar year, depending on the contributor’s modified adjusted gross income, many savers prefer the 529 College Savings Plan.
529 College Savings Plan
The 529 is operated by a state with varying tax advantages and other potential incentives to save for post-secondary education.
The 529 accounts grow tax-deferred with tax-free distributions, as long as they’re applied to qualified college-related expenses. Depending on the state’s plan, some of the money contributed to a 529 could be tax deductible in that state.
One huge advantage over Coverdells is that the 529 allows much larger amounts of money to be saved. Many plans have contribution limits in excess of $250,000. And generally there are no income limitations on the donor.
Similar to the Coverdell, the 529 allows account holders to designate another family member as beneficiary, providing more flexibility and control.
College investing strategy
To lower the risk of losing college funds when the student needs them, plan to gradually shift weight from stocks to bonds as the student advances through high school.
Another feature is the ability to fast-forward contributions. A donor could make up to five years’ worth of 529 contributions at once. With the current gift tax exclusion at $14,000 per year per donor, a couple of grandparents could get $70,000 out of their estate.
In federal calculations for need-based financial aid, 529 plans held by the parents of a college student are treated as parents’ assets, which count less against eligibility than if they belonged to the student.
If a grandparent or someone other than the parent or student owns the 529 account, the assets are not included on the federal aid application. However, distributions are considered as income for the student and count against the student’s financial needs.
For this reason, I typically suggest the 529 plan be held in a parent’s name, in which case money distributed for education expenses is not included in the financial aid calculation. Grandparents and anyone else can still add to the account.
Uniform Transfer to Minors Account – UTMA
These flexible accounts are not restricted to education expenses, and they don’t have income or contribution limits. But they do cede control to the beneficiary at the age of majority (18 to 25, depending on the state).
The only restriction on UTMA withdrawals is that the money be used for the benefit of the minor.
UTMAs make sense if an account custodian plans to fund non-education related expenses for the child or is looking to lower income taxes by shifting liability to the minor. Custodians also can lower the size of their estate by taking advantage of the annual gift tax exclusion, which in 2014 is $14,000 per year per donor.
Please keep in mind that an UTMA is an outright gift to the minor and is irrevocable. Unlike a 529 or Coverdell, you cannot change the beneficiary.
A potential drawback is that the UTMA weighs more heavily against students on financial aid applications because it counts as an asset of the student.
The UTMA, Coverdell and 529 each offers varying advantages for saving for education. Just make sure you keep your priorities straight when you’re planning to put aside money for your children and grandchildren.
Your first focus should be on putting your retirement plan in order. If you are already retired, ask yourself if your income is sufficient. If you are still saving, are you ahead of pace to maintain your standard of living at retirement? If so, then all three accounts, for different reasons, may be worth a look.
Steve Giles is a vice president and advisor at Landaas & Company.
(initially posted March 21, 2014)