Investing for College in a Low-Tax Environment

By Gregory J. Cook, EA, CPA Author

 

The tax legislation introduced in 2001 and 2003 created incentives and enhanced options for investing for education. The most popular vehicles for saving for college include the Coverdell Education Savings Account (ESA), 529 Savings Plans, Uniform Gift to Minors Act (UGMA) accounts or traditional investment accounts.

 

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) created a tax incentive for educational savings. The 529 Savings Plan and the Coverdell ESA are funded with after-tax dollars, but any growth in assets would be tax-free if the assets in the account are used for qualified educational expenses. While tax-free growth is a great incentive, there is no guarantee your investment will grow and it may even lose value, depending on what investment choices you make within the account.

 

A Coverdell ESA allows you to invest in any variety of investment types, including stocks, bonds, mutual funds and cash equivalents. There are income limitations. Single taxpayers with a modified adjusted gross income (MAGI) of less than $95,000 and married couples with a MAGI of less than $190,000 are eligible to make a full contribution of $2,000 per beneficiary. Assets accumulated in a Coverdell ESA must be used for qualified educational expenses, including college expenses. If the assets are withdrawn for any other purpose, you will pay ordinary income taxes on any gains and a 10% penalty. With a Coverdell ESA, you work with your financial advisor to create a portfolio of investments that fit your family’s education savings needs.

 

A 529 Savings Plan has no income restrictions and provides an opportunity to invest much larger amounts, although you would incur gift taxes for contributions over the annual gift exclusion of $11,000 ($22,000 for married couples). 529 Plans do allow you to group five year’s worth of gifts and invest $55,000 ($110,000 for couples) in the first of a five-year period. Your investment options are limited to those provided by the plan you have chosen. Most have investment options that include equity investments similar to mutual funds and fixed income funds that invest in bonds and cash equivalents. Assets accumulated in a 529 Plan must be used for qualified educational expenses to qualify for federal tax-free status. These expenses are limited to post secondary education. If the assets are withdrawn for any other purpose, you will pay taxes on any gains and a penalty.

 

The tax act of 2003 made UGMAs and traditional investment accounts more attractive as options for saving for education expenses. The 2003 Tax Law reduced the tax rate on long-term capital gains to 5% for taxpayers in lower income tax brackets, and 15% for those taxpayers in higher tax brackets. Like 529 Plans and ESAs, assets invested in UGMAs and investment accounts are not guaranteed to grow and may lose value depending on the investment choices you make within the account.

 

UGMAs and investment accounts do not have the requirement of using assets for education. In an UGMA, you place assets in an account for a minor (under age 18 or 21, depending on the state). Children under the age of 14 have capital gains taxed at their parents’ tax rate, but children age 14 and older are taxed at their own rate. As long as their income is less than $28,400 per year (in 2003), he or she can qualify for the low, 5% tax rate on long-term capital gains. UGMAs and investment accounts have no income limits and you may invest any amount you wish, although you would incur gift taxes for contributions over the annual gift exclusion of $11,000 ($22,000 for married couples). In both accounts you may select any investment type that you wish. With UGMAs and investment accounts, you work with your financial advisor to create a portfolio of investments that fit your family’s education savings needs.

 

While recent tax legislation has made investing for education more appealing than in past years, it is important to work with a qualified financial professional to see how investing for educational purposes fits into your overall plan. A financial professional will be able to help you select the investment option that best complements your current investment plan.

 

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