The College-Savings Superpage

Published September 06, 2005

| Smart Money

The tax breaks for college are better than ever -- if you know the ins and outs. Here's a guide.

Think the only way you'll be able to foot your son's or daughter's future college bills is by winning the lottery? Think again. While the soaring costs of college can be overwhelming, a bit of careful planning can help you leap over this financial hurdle. In fact, thanks to some generous tax code changes, it's now easier than ever to save.

But it also can be terribly confusing. Should you invest in a 529 plan or an education savings account? When you file your taxes, should you claim the Lifetime Learning Credit or the Hope Scholarship Credit? That's where our College Saving Superpage comes in. We've broken down your college-savings options into two categories: your investment options (which you'll see below) and your tax breaks (located on the following page). And we've created a worksheet to help you evaluate the dozens of 529 plans out there.

The idea: to help you find the best way to stretch your college dollars. That's something even those of us who didn't earn an A in accounting can appreciate.


Does the Account Grow Tax-Free?
Taxable Investment Account in Parent's NameNo. Regular tax rules apply. For investments held more than one year this typically means capital gains are taxed at a maximum rate of 15%. Ditto for dividends. For short-term gains and interest, your regular tax rate (up to 35%) applies.
529 Qualified Tuition Plan (QTP): College-savings accountYes. Withdrawals are federally tax-free when used for qualified higher-education expenses. In most states, withdrawals are also state-tax-free. Some states also offer in-state residents a state-tax deduction or credit on contributions. (In some cases, the state-tax break is limited to a certain dollar amount.) Earnings on nonqualified withdrawals will be taxed as ordinary income and are subject to a 10% IRS penalty. The penalty may be waived if the account beneficiary (the college-bound child) receives a scholarship, becomes disabled or dies.
529 Qualified Tuition Plan (QTP): Prepaid tuition planYes. Withdrawals from state-sponsored plans are federally tax-free when used for qualified higher-education expenses. In most states, withdrawals are also state-tax-free. Some states also offer in-state residents a state-tax deduction or credit on contributions. (In some cases, the state-tax break is limited to a certain dollar amount.) Earnings on nonqualified withdrawals will be taxed as ordinary income and are subject to a 10% IRS penalty. The penalty may be waived if the account beneficiary (the college-bound child) receives a scholarship, becomes disabled or dies. Qualified withdrawals from the Independent 529 plan, which targets select private schools, are also federally tax-free for qualified expenses.
Coverdell Education Savings Account (ESA)Yes. Withdrawals are tax-free when used for qualified higher-education expenses as well as elementary- and secondary-school expenses. Earnings on nonqualified withdrawals are taxed as ordinary income and subject to a 10% penalty.
Custodial Account: UGMA/UTMANo. Regular tax rules apply, although at the child's tax rate. If the beneficiary (the college-bound child) is under age 14, he or she will be subject to the kiddie tax if annual investment income and gains exceed $1,600.
Crummey TrustNo. Regular tax rules apply, although at the child's tax rate. If the beneficiary (the college-bound child) is under age 14, he or she will be subject to the kiddie tax if annual investment income and gains exceed $1,600.

Who's Eligible?
Taxable Investment Account in Parent's NameAnyone.
529 QTP: College-savings accountWith many state plans, anyone is eligible, regardless of where they live. There are exceptions, however. In some cases, the contributor or student must be state resident.
529 QTP: Prepaid tuition planWith many state plans, anyone is eligible, regardless of where they live. There are exceptions, however. In some cases, the contributor or student must be state resident.
Coverdell ESAEligibility phases out for contributors who are married, filing jointly with AGIs between $190,000 and $220,000 and for singles with AGIs between $95,000 and $110,000. Children can contribute to their own accounts.
Custodial Account: UGMA/UTMAAnyone.
Crummey TrustAnyone.

How Much Can I Contribute?
Taxable Investment Account in Parent's NameUnlimited.
529 QTP: College-savings accountVaries by state plan. Highest limits are $300,000 per beneficiary. Generally, an annual gift to one beneficiary greater than $11,000 will erode your $1 million gift-tax exemption, although an individual can make up to $55,000 worth of contributions upfront without gift-tax implications, provided no additional contributions are made over next five years.
529 QTP: Prepaid tuition planVaries by state plan. Maximum contributions are typically based on the current age of the child and the average cost of in-state universities. Generally, an annual gift to one beneficiary greater than $11,000 will erode your $1 million gift-tax exemption, although an individual can make up to $55,000 worth of contributions upfront without gift-tax implications, provided no additional contributions are made over next five years.
Coverdell ESA$2,000 annually. If your AGI is between $190,000 and $220,000 (if married, filing jointly) or $95,000 and $110,000 (if single), maximum contributions will be reduced proportionately.
Custodial Account: UGMA/UTMAUnlimited. Although any annual gift greater than $11,000 per beneficiary will erode your $1 million gift-tax exemption.
Crummey TrustUnlimited. Although any annual gift greater than $11,000 per beneficiary will erode your $1 million gift-tax exemption.

How Can I Allocate the Account?
Taxable Investment Account in Parent's NameHowever you'd like.
529 QTP Plan: College-savings accountYou're limited to the handful of mutual funds provided in the plan. Some plans will automatically adjust investments to a more conservative allocation as deadline to college approaches.
529 QTP Plan: Prepaid tuition planAllocation is set by plan. Typically the account is intended to grow at the rate of tuition inflation at the designated schools.
Coverdell ESAHowever you'd like.
Custodial Account: UGMA/UTMAHowever you'd like.
Crummey TrustHowever you'd like.

What Can Withdrawals Be Used For?
Taxable Investment Account in Parent's NameAnything.
529 QTP: College-savings accountPost-secondary education. Expenses include: tuition, fees, books, supplies, equipment required for enrollment or attendance, and in most cases, reasonable costs of room and board (provided the beneficiary is enrolled at least half the time).
529 QTP: Prepaid tuition plansPost-secondary education costs. Expenses include: tuition, fees, books, supplies, equipment required for enrollment or attendance, and reasonable costs of room and board (provided the beneficiary is enrolled at least half the time).
Coverdell ESAExpenses related to higher education as well as elementary- and secondary-school expenses, including costs to attend private and religious schools. Qualified expenses include books, supplies and equipment as well as contributions to a section 529 QTP and, if the designated beneficiary is enrolled at least half the time at an eligible school, room and board.
Custodial Account: UGMA/UTMAIf beneficiary is not yet of age, withdrawals can be taken for his or her benefit generally for any reason, although rules vary by state. Once beneficiary is of age, he or she gains control. Withdrawals can then be used for anything.
Crummey TrustWhenever a contribution is made, the beneficiary is permitted to withdraw that contribution within a set period of time (often 30 days). If the contribution isn't withdrawn within that window, then the beneficiary can't tap into the account until he or she reaches the age designated in the trust document, at which time the beneficiary takes control of the account. Trustee can withdraw funds for educational expenses or other expenses that benefit the beneficiary.

Can I Change Beneficiaries?
Taxable Investment Account in Parent's NameNot applicable. The account is yours to do with as you wish.
529 QTP Plan: College-savings accountYes. Beneficiaries can be changed without income-tax consequences to family members of original beneficiary, including cousins. However, there are gift-tax consequences if the new beneficiary is in a younger generation than the original one.
529 QTP Plan: Prepaid tuition planYes. Beneficiaries can be changed without income tax consequences to family members of original beneficiary, including cousins. However, there are gift-tax consequences if the new beneficiary is in a younger generation than the original one.
Coverdell ESAYes. Beneficiaries can be changed without tax consequences to family members provided the new beneficiary is under age 30. However it appears that the original beneficiary must consent to any change. If the account still has money in it after the original beneficiary turns 30, it must be distributed to him or her or rolled over to new beneficiary.
Custodial Account: UGMA/UTMANo.
Crummey TrustsNo.

What Are the Financial-Aid Implications?
Taxable Account in Parent's NameViewed as a parental asset under the federal methodology (which is used for federal and most state aid) and institutional methodology (generally used by private colleges for their endowment funds). With the federal methodology, this means that a financial-aid officer could count up to 5.7% of the account balance when assessing your child's financial-aid eligibility. With the institutional methodology, net assets will be assessed at a rate between 3% and 5%, depending on the total amount. Some private colleges may assess need differently.
529 QTP: College-savings accountUnder the federal methodology, viewed as an asset of the contributor. If the parent set up the account, this means that a financial-aid officer could count up to 5.7% of the account balance when assessing your child's financial-aid eligibility. Under the institutional methodology, this is viewed as a parental asset, which can be assessed at a rate between 3% and 5%, depending on the total net asset amount. Some private colleges may assess need differently.
529 QTP: Prepaid tuition planUnder the federal methodology, this money is viewed as an outside resource (similar to a scholarship). This means the beneficiary's financial aid need could be reduced dollar-for-dollar. Under the institutional methodology, this is viewed as a parental asset, which can be assessed at a rate between 3% and 5%, depending on the total net asset amount. Some private colleges may assess need differently.
Coverdell ESAUnder the federal methodology, viewed as the student's asset. Children are typically expected to contribute 35% of their assets to public schools; 25% to private. Under institutional methodology, viewed as parental asset, which will be assessed at a rate between 3% and 5%, depending on the amount. Some private colleges may assess need differently.
Custodial Account: UGMA/UTMAViewed as the beneficiary's asset (i.e., the student's). Children are typically expected to contribute 35% of their assets to public schools; 25% to private. Some private colleges may assess need differently.
Crummey TrustViewed as the beneficiary's asset (i.e., the student's). Children are typically expected to contribute 35% of their assets to public schools; 25% to private. Some private colleges may assess need differently.

Who Are the Best Candidates for This Type of Account?
Taxable Investment Account in Parent's NameParents who want the greatest flexibility possible. This type of account makes sense if you aren't sure if your kids will go to college -- or if you aren't sure you want to foot the bill.
529 QTP: College-savings accountThose looking to contribute substantial amounts to a tax-free college fund. The tradeoff is that you have reduced investment options. And if the beneficiary decides not to go to college, the account must be rolled over to another family member to avoid taxation and a penalty on earnings.
529 QTP: Prepaid tuition planFor those who are satisfied earning a rate of return that matches the college-cost inflation rate for the schools designated by the plan. In most cases, this means you should be fairly certain that the beneficiary will go to one of the schools included in the plan.
Coverdell ESAParents who want maximum control over their investment options, and who don't have more than $2,000 to contribute on an annual basis.
Custodial Account: UGMA/UTMAThose looking to transfer assets to a young beneficiary to reduce taxes and who are comfortable turning over control of the account to the beneficiary once he or she reaches the age of majority.
Crummey TrustThose looking to transfer substantial assets to a young beneficiary to reduce taxes, but who are not comfortable turning over control of the account to the beneficiary once he or she reaches the age of majority.

What's AGI?
Your adjusted gross income is the number at the bottom on page 1 of your 1040. Specifically, it's your gross income minus so-called above-the-line deductions. These are deductible IRA contributions (as well as deductible SEP, SIMPLE and Keogh contributions), the student-loan-interest deduction, deductible contributions to medical savings accounts, moving-expense deductions, half of the self-employment tax paid by self-employed individuals, the deduction for health-insurance premiums paid by self-employed persons, the deduction for higher education expenses; the deduction for penalties on the early withdrawal of savings and the deduction for alimony payments. AGI doesn't include the standard deduction or itemized deductions. However, the key for calculating your eligibility for education savings accounts is actually modified AGI, or MAGI. This is your AGI (as explained), increased by certain foreign earned income and housing costs for those living abroad as well as certain offshore income, all of which is excluded from taxation.

What are UGMAs/UTMAs?
These are custodial accounts for kids that can be set up under applicable state law. The custodian (generally the parent) maintains control over account until beneficiary reaches age of majority, although the account is taxed at the beneficiary's rate (assuming the kiddie tax doesn't apply). There is very little difference between an UTMA (Uniform Transfers to Minor Act) account and an UGMA (Uniform Gifts to Minor Act) account, although UGMAs have stricter rules as to what can be held in the account. A handful of states mandate UGMAs, while most mandate UTMAs.

What's a Crummey Trust?
A Crummey Trust is a trust set up for a minor, often to hold funds intended for the child's future higher education costs. The beneficiary is doled out money according to the terns of the trust document. These trusts allow you to have longer control over the account than an UTMA or UGMA, although they're costly to set up. Be prepared to spend at least $1,000.

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