Coverdell, Custodial or 529? How to Choose

First the grim news: The cost of a college education has continued to increase at rates well above the general inflation rate in recent years. Now the good news: Your options for setting aside college money in tax-efficient investment accounts have increased as well. We’ll examine three of the most popular: 529 plans, custodial accounts and Coverdell accounts.

The Lowdown on 529 Plans

Created in 1996 and named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states, but in some cases may also be sponsored by qualified educational institutions.

College savings plans—a type of 529 plan. Many of these plans are national plans: no matter which state or school sponsors them, residents of any state can participate.

The potential advantages of 529 plans include:

• Tax-free earnings — Earnings in a 529 plan accumulate free from taxes, and qualified withdrawals are federally tax free. Withdrawals may be exempt from state taxes as well (tax rules vary from state to state). Nonqualified withdrawals from a 529 plan may be subject to income taxes and a 10% additional federal tax.
• Gift tax benefits for contributors — A contribution to a 529 plan is considered a gift for federal tax purposes. Tax rules currently let you give up to $13,000 in 2011 to as many individuals as you choose, free from federal gift taxes. Gifting schedules can also be accelerated through a lump-sum contribution of $65,000 to a 529 plan in the first year of a five-year period.
• Generous contribution rules — Lifetime contribution limits on 529 plans vary from state to state, but often exceed $200,000 per beneficiary, including earnings. In addition, there usually are no income restrictions on contributors to a 529 plan.
• Account control — The individual who creates a 529 plan account on behalf of a beneficiary generally maintains complete control over the account. This is not the case with Coverdell Education Savings Accounts or certain types of custodial accounts. Account owners may also change beneficiaries.

Finally, contributions to 529 plans may provide a state tax deduction for residents of the sponsoring state. As with all tax-related decisions, consult your tax advisor. Withdrawals for expenses other than qualified education expenses are subject to income tax and an additional 10% penalty on earnings. You should consider a 529 plan’s fees and expenses such as administrative fees, enrollment fees, annual maintenance fees, sales charges and underlying fund expenses which will fluctuate depending on the 529 plan invested in and the investments chosen within the plan. You should also consider the inherent risks associated with investing in 529 plans, such as investment return and principal fluctuation, which will also vary based on the investments made within the plan. More information is available in each plan’s official statement, which should be read carefully before investing.

UGMA/UTMA Accounts: Awarding Custody

Of course, not all college savings strategies require the involvement of a college or a state government. For example, by following the guidelines established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA)—each state uses one or the other—adults such as parents and grandparents can establish and contribute to a custodial account in a minor's name without having to establish a trust or name a legal guardian.

Contributing to an UGMA/UTMA account can accomplish two goals simultaneously: helping a future student prepare for college costs and reducing the value of a contributor's taxable estate. UGMA/UTMA accounts also offer favorable tax treatment of investment earnings. For example, the first $950 of earnings is tax free each year. If the minor is under 19, earnings in excess of $950 but not above $1,900 are taxed at the child's rate. If earnings exceed $1,900 for children under 19, the income is taxed at either the parents' rate or the child's rate, whichever is higher. If the child is older than 19, all income is taxed at his or her rate. Note that the age limit increases to 24 for a full-time student if the child doesn't have earned income in excess of half of his or her annual support.

Despite the obvious appeal of UGMA/UTMA accounts, it's worth noting that the assets in the account belong to the child, not to the contributor. When the child reaches legal adulthood at age 18 or 21, depending on the state, he or she is free to spend the money with no restrictions. In other words, contributors cannot force that individual to use the money for college costs.

Coverdell Benefits

Coverdells are qualified investment accounts that allow nondeductible contributions of up to $2,000 annually per beneficiary. Earnings in the account are not taxed, and as long as withdrawals are used for qualified education expenses, they are tax free as well. Assets in a Coverdell must be used before the beneficiary's 30th birthday. Keep in mind that the designated beneficiary of a Coverdell account is free to take withdrawals at any time, but any amount in excess of his or her qualified education expenses will be taxable as income. A 10% additional federal tax may also apply.

Coverdells also have a special feature unavailable with 529 plans: Qualified withdrawals may be used to pay for an elementary, secondary, or college education. Withdrawals from 529 plans can only be used for college expenses. Unlike 529 plans, Coverdells impose income eligibility limits on contributors. Single filers with modified adjusted gross incomes of more than $110,000 and joint filers with incomes of more than $220,000 cannot contribute.

The deadline to contribute to a Coverdell is generally April 15, the same deadline that applies to IRAs. Before making a decision about a Coverdell, evaluate the investment options, fees, and services offered by competing financial institutions that provide the accounts. Also, bear in mind that rules governing the Coverdell Education Savings Account will revert to 2001 rules in 2013 unless Congress reenacts them.

Finally, when choosing a college investment vehicle, remember that it may not be a “one or the other” decision. It may make sense for you to contribute to more than one type of account simultaneously. Speak with a financial and tax advisor about your particular needs.