College Savings Plans: Advantages and Disadvantages

The earlier you start saving for college, the more money you will accumulate. However, keep in mind that it’s never too late to start saving.

There are several avenues you could take when you start saving for your/your child's education. These college saving methods have advantages as well as disadvantages and can often be hard to understand. There are many fine details to consider with each. The following information will give you some basic knowledge to help you choose a savings avenue, but you may want to consult with your own accountant or personal financial planner for further assistance.

529 Plans
The most popular method of saving for college is through section 529 plans. There are two types of section 529 plans: prepaid tuition plans and college savings plans.

Prepaid tuition plans allow a family to lock in the current price of college for future use. For instance, if a family purchases shares worth one year's tuition, these shares will always be worth one year's tuition even after several years when tuition rates have increased.

Advantages:

Risk-free way to pay for college. Invested money cannot be lost.
Possible tax breaks. Prepaid tuition plans are exempt from federal income tax and are often exempt from state and local taxes.
Guaranteed. Accounts are guaranteed by state governments.

Disadvantages:

Limited investment growth potential. This is because the plans are a low-risk investment. Most plans only offer 4 to 5 percent interest per year.
Limited to state residents. Account owner or beneficiary must be a state resident when the account is opened.

Section 529 college savings plans allow parents to set aside money for their child's education and let it grow tax-free. Investments are subject to market conditions.

Advantages:

Tax breaks. Investments grow tax free for as long as money stays in the program, and when money is taken out for education purposes (i.e. tuition, room and board, books, etc.), the parent won't pay federal taxes on any part of it.
Flexible. The beneficiary (the student) can attend any accredited college in the United States and many institutions abroad. Benefactors can change beneficiaries as often as they like. Accounts can be opened for any number of people regardless of age.
Easy to manage. Set up your account and your money is managed for you.

Disadvantages:

Potential to lose money. Since the investment is directly related to the stock market, the college savings plan has the potential to lose money.
Possible penalties. If money is taken out of a 529 plan for purposes other than education, the parents will be charged a 10 percent penalty on the earnings and have to pay federal taxes on the earnings.

Credit Card Rebate and Affinity Programs
Affinity programs offer a rebate to consumers in exchange for buying certain products/services or shopping at certain retailers. These programs provide rebates in the form of tuition benefits, such as credits to a section 529 plan. All parents have to do is register their credit cards with the affinity program of choice, and these programs track purchases at participating stores. Affinity programs that offer college saving rewards include: Upromise, Babymint, EdExpress, and SAGE Tuition Rewards Program.

Advantages:

Flexible contributions. Aunts, uncles, and grandparents can also contribute to educational costs by registering their credit cards.
Keep same spending habits. Because the retailer networks associated with these programs are reasonably large, most families will earn some rebates without changing spending habits.

Disadvantage:

Supplemental savings route. The money earned from these programs will not likely cover the entire college expense.

UGMA and UTMA Custodial Accounts
Because parents cannot just transfer assets to their minor children, they must transfer the assets to a trust. Custodial accounts are the most common trusts for minors and include UGMA and UTMA accounts. The Uniform Gift to Minors Act (UMGA) allows a minor to own securities without requiring an attorney to prepare trust documents. The Uniform Transfer to Minors Act (UTMA) is similar to the UMGA, but it also permits minors to own other types of property, such as real estate. To create a custodial account, the benefactor must select a beneficiary and then gift the money to the account. The money belongs to the minor, but the benefactor controls the rights on the account until the minor reaches 18 or 21, depending on whether it is a UGMA or a UTMA.

Advantages:

Money does not have to be spent on school. Even though the money does not have to be spent on school, it still has to be spent for the benefit of the child. An acceptable item to spend the money on would be a computer for the child. The parent cannot spend the money for his or her own benefit and cannot use the money for food, clothing, or shelter because these are considered parental obligations.
No contribution ceilings. Custodial accounts have no ceiling on the amount one can contribute.

Disadvantages:

Parental loss of control. When the minor reaches adulthood, he/she can use the money for any purpose without permission from the benefactor. Because of this, there is no guarantee that the child will use the money for educational purposes.
Transferability of the account. Since the beneficiary's name is on the custodial account, the funds are not transferable to another beneficiary.

2503(c) Minor's Trust
A section 2503(c) Minor's Trust holds gifts in trust for a child until the child reaches age 21. It was established so that gifts to minors in trust may qualify for the gift tax annual exclusion. For a gift to qualify for the annual gift tax exclusion, the recipient must be able to receive the gift immediately. Section 2503(c) is the only exception to this rule.

Advantage:

Tax break. The recipient can receive the trust in the future and still qualify for the gift tax exclusion.

Disadvantage:

High setup and administration costs. Because an attorney is usually involved in the drafting of a trust document, there are high setup and administrative costs.

Coverdell Education Savings Accounts
Coverdell Educations Savings Accounts are plans that allow account owners to invest for college-related expenses.

Advantages:

Tax benefits. Tax-free withdrawals are allowed.
Transferability of accounts. Account(s) can be transferred to another family member of the beneficiary.

Disadvantage:

Withdrawal time limit. The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.

Due to the extent of this article, these are only some advantages and disadvantages of college savings avenues. Each of these plans has multiple investment options and their own set of rules and/or restrictions. To find out more information on your options, visit www.nasfaa.org or talk to your accountant/financial planner and start saving for your/your child's future.

Posted: 5/2/2003