Helping Clients Save for College

by Jeffrey S. Hanson, CPA, Traphagen Financial Group  – October 11, 2017
Helping Clients Save for College

Many clients rely on CPAs for advice when saving for college and want to know the best approach. There are several effective methods.

529 Plans

A great vehicle to save for college is a 529 plan. There are two types of 529 plans: prepaid tuition plans and education savings accounts. A prepaid tuition plan allows you to prepay your tuition at eligible colleges and is limited to the actual amount of higher education costs for the beneficiary. The second and more common 529 plan is the education savings account which allows you to contribute to an account established for paying a student’s qualified education expenses at an eligible educational institution. The education savings account growth is tax free if used solely for higher education expenses (post high school). Only the profit distributions not used for post high school qualified higher education expenses would be subject to tax and penalty. Qualified expenses include tuition and fees, books, supplies, qualified equipment, and room and board.

One of the benefits of the 529 plan is the high contribution limits ranging by state with certain states exceeding $400,000 for contribution limits per beneficiary. You are allowed to open a 529 plan in any state you wish. If the contribution is more than $14,000 per person, a gift tax return must be filed to report the gift. An election of five times the annual exclusion may be made to spread the gift over five years to avoid using your federal estate exemption on the gift. If the beneficiary decides not to attend college or receives a scholarship you still have options. If the beneficiary receives a scholarship or other tax-free educational assistance, you are eligible to distribute the 529 plan penalty free up to the amount of the scholarship or other tax-free educational assistance. The 529 plan will count as the owner’s asset (not the beneficiary’s) for financial aid calculations. Parent’s assets count towards the expected family contribution at a rate of 5.64 percent compared to the student’s assets which count at a rate of 20 percent. A higher family contribution will reduce the financial aid eligibility.

Coverdell Education Savings Accounts

The Coverdell Education Savings Account has become outdated due to the creation of the 529 plan in 1996. The Coverdell has an annual contribution limit of $2,000 per year per beneficiary, and the growth is tax-free if used for qualified education expenses. The main benefit that the Cover­dell has over the 529 plan is the ability to use the funds for elementary, grammar and high school as well as qualified colleges, universities, vocational schools or other postsecondary educational institutes.

UTMAs, UGMAs and Roth IRAs

Parents who are not sure if their child will be attending college and want to avoid the potential 10-percent penalty if a 529 plan or Coverdell account is used may consider other vehicles. In this situation a Uniform Gift to Minors (UTMA)/Universal Transfer to Minors (UGMA) or Roth IRA may be used.

The UTMA/UGMA is a custodial account owned by the minor child with the parent or other guardian listed on the account. This type of account would count as a student’s assets for financial aid calculations. The income earned by a UTMA/UGMA would also be reported on the child’s tax return. For 2017, investment income of $2,100 would have an effective tax rate of only 5 percent federally. Income in excess of $2,100 would be subject to the “kiddie tax” and would be taxable at the parent’s tax rate.

A Roth IRA is a retirement account funded with after-tax money, and the growth is tax-free if held for five years and the taxpayer is age 59 ½ or older. The contributions can be withdrawn first with no tax or penalty. Roth IRAs do not count as an asset for financial aid calculations. The growth in a Roth IRA would be subject to income tax if used for education expenses when under age 59 ½ but would be exempt from the 10-percent penalty if used for qualified higher education expenses. Contributions to a Roth IRA are limited to the lesser of earned income or $5,500 for taxpayers under age 50.

Your clients’ specific circumstances would dictate which educational funding option is best for them. When deciding the account type and investment allocation, one should consider timeframe, risk tolerance and other factors including financial aid considerations. 


Jeffrey S. Hanson

Jeffrey S. Hanson

Jeffrey S. Hanson, CPA, PFS, AEP, CFP, is a financial advisor at Traphagen Financial Group, specializing in individual, trust and estate tax returns and wealth management services. He is a member of the NJCPA.

This article appeared in the September/October 2017 issue of New Jersey CPA magazine. Read the full issue.