Steve TeSelle, CFA, CFP ™
April 2000
Editor's Note, July 2002: The tax laws have changed, again. Now earnings from 529 plans are exempt from federal tax, and the annual limit on Education IRAs has increased from $500 to $2,000. Inevitably, tax laws will continue to mutate, but the tradeoff of control versus tax benefits will remain. Read on to determine whether this article has relevance to your situation or not.
You really want to do the right thing and save an enormous amount of money so your child can attend the prestigious (and expensive) university he or she yearns for. But how to save in a tax-efficient way that also leaves you some flexibility in case your child decides to forego college and join the pro wrestling circuit. That’s the big question.
You have a number of options: State-sponsored plans; Uniform Gift to Minors or Uniform Transfer to Minors; Education IRAs; or keeping all the savings in the parents’ name. Once your child’s in college, you can utilize retirement assets and home equity to make ends meet, but let’s focus on savings vehicles that can go a long way to meeting those hefty college bills.
In Colorado, we have two state-sponsored plans: the Prepaid Tuition Plan and The Scholars’ Choice Plan. The names alone indicate the better option - scholars are the smart people, right? With the Prepaid Tuition Plan, you buy tuition credits in the student’s name. 100 units equal the average cost of one year of tuition. The key is that you can buy the units now and be protected from tuition inflation. The catch is that in Colorado, many schools are public institutions that are limited by the Tabor Amendment - an amendment passed by the voters that limits revenue and expense growth for public institutions. So buying these units is akin to buying a bad bank CD (maybe 3%). Also, the program has been deducting some kind of administrative fee that lowers that return even further. The only case in which this program makes sense is if stocks and bonds return less than inflation over the time period that you’re saving.
The scholars are definitely opting for the Scholars’ Choice Plan. This plan is essentially an investment in Solomon Smith Barney mutual funds on a tax-deferred basis. Why would you restrict yourself to Solomon Smith Barney? So you can get the tax deferral on all earnings; and when the funds are withdrawn and used for education, the earnings are free of Colorado state tax (no matter where the student matriculates) and are taxed at the student’s rate for Federal tax. The money has to be used for qualified expenses, which means tuition, room and board, books and supplies and equipment necessary for matriculation. Starting in January 2001, contributions will be deductible from Colorado income tax. So you trade tax deferral for flexibility - just like retirement plans.
There are three investment options: 50% equity fund, 50% bond fund; changing allocation among equity, bond and money market funds based on the child’s age; and a changing allocation based on years until enrollment (for adult students). A 100% equity option and 100% fixed income option are being added in September. Annual expenses on the funds are about 1%.
You can get started with small amounts for both of these programs -- $25 for Prepaid Tuition and $50 for Scholar’s Choice. At the other end of the spectrum, you can give up to $10,000 per year free of gift taxes (married couples can give up to $20,000). The maximum that you can have in one or both programs is $150,000.
So if your child opts for pro wrestling over college, then what? You can leave the money alone and hope your child comes to his senses, you can transfer the account to a relative of the original beneficiary, or you can take the money out subject to your tax rate plus a 10% penalty.
Many states now have similar plans. Look for plans with low
expenses and as much flexibility as possible. 
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Education IRAs have seemed to me like one of the less-effective approaches to college saving. The maximum annual contribution per beneficiary per year is $500. That probably buys a tote bag in the college bookstore. The advantage is that earnings grow tax-free. The contributions are not deductible, but as long as distributions are used for qualified expenses, the distributions are not taxed.
There are a few catches here: your ability to contribute to an Education IRA phases out between incomes of $150,000 and $160,000 (married, filing jointly), or $95,000 and $110,000 (single). Also, you can’t make any contributions to an Education IRA in the same year that you’ve made contributions to a state-sponsored plan. And you can’t claim the Hope Tax Credit or Lifetime Learning Credit in any year that there is an IRA distribution. If distributions aren’t used for qualified expenses, the distributions are taxed at the beneficiary’s rate plus, that’s right, the ubiquitous 10% penalty.
Pro wrestling? As with the state plans, you can transfer the
IRA to another family member of the beneficiary who is under 30 years old.
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These accounts allow you to put the investments into the child’s name. When you set up the account with the broker or custodian, you designate the account as UGMA or UTMA. One of the parents is typically the custodian, who is responsible for the account until the child reaches a certain age (either 18 or 21, depending on the state). The advantage is in the wide range of investment options - you’re not restricted to a single mutual fund family (UTMA allows more types of investments than UGMA). And when the child is less than 14 years old, earnings are not taxed below $700, taxed at the child’s rate up to $1,400, and at the parents’ rate above $1,400. Another advantage to this option is that the money does not have to be used for "qualified educational expenses." You have some flexibility. The hassle is that if your child joins the wrestling crowd, well, that money is his whenever he’s old enough.
If you use UGMA/UTMA, you should use investments with relatively
low distributions when the child is less than 14, to keep the amount taxed
at the parents’ rate to a minimum. After 14, the ceiling below which distributions
are taxed at the child’s rate jumps to nearly $30,000.
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Of course, you can keep everything in your name. If you like
control, this might sound best to you. That’s fine. Control isn’t good or
bad; it just is. The big disadvantage, however, is that you get taxed at your
rates, which are presumably higher than your child’s. If you’ve saved a significant
chunk for college, those tax payments can really hurt.
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Fortunately, you don’t have to make an all or nothing decision. You can use more than one of these options. The points to consider are: How much flexibility do you need or want? Investing in your own name or via UGMA/UTMA offers more flexibility than the other options, both in terms of investing options and how the money is spent or distributed. How much time do you have before college starts? The more time you have, the juicier that tax-deferral is. How much control do you want over the proceeds? Keeping the savings in your name offers the most; UGMA/ UTMA offers the least.
Use more than one option, subject to gift tax limits, and you can have a college savings plan that gives you the balance you want among control, flexibility, and tax reduction.
If you have any questions about any of these options (or anything
else), feel free to call me at (303) 733-4999.
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