Best Estate Planning Strategies to Help with Education

Numerous estate planning vehicles are available to help prepare for education expenses. Parents and grandparents need to compare carefully to choose right vehicle for their estate planning.

The Section 529 college savings plan gets the most attention. It is open to anyone regardless of income level. The investment earnings compound tax-free and can be withdrawn tax free if used for qualified education expenses.

The maximum estate planning contribution per beneficiary varies by state but generally is $200,000 to $300,000. Contributions qualify for the annual gift tax exclusion. Up to the next five years’ worth of annual exclusions can be used in one year. The account is excluded from the owner’s estate.

Many states allow deductions against their income taxes for contributions, though there are no federal income tax deductions. The owner who contributes to the account often can get the money back and can change the account’s beneficiary.

There often is a menu of estate planning investment options determined by the state sponsoring the plan. Many 529 plans have several layers of fees, and it can be difficult to determine all the fees.

Another choice is the Coverdell Education Savings Account, once known as the Education IRA.

Annual contributions are limited to $2,000 per child, from all contributors combined. Coverdell accounts are offered by financial services firms, such as mutual funds, and generally offer all the investment options available through the firm. They also are likely to charge lower fees than many 529 plans.

Another potential advantage is that Coverdell account balances can be used to pay for qualified education expenses at any level, such as private elementary education. Section 529 plans can be used only for college.

There are no federal or state income tax deductions for contributions to Coverdell plans.

Coverdell contributions are limited to individuals whose modified adjusted gross incomes are below $220,000 on joint returns or $110,000 on individual returns.

A problem with Coverdell accounts is that not all financial services firms offer them. Fidelity does not. Major firms that do offer them include Vanguard, T. Rowe Price, and Charles Schwab & Co. Some firms might list them under a generic name, such as Education Savings Accounts.

There also are the traditional Uniform Gift to Minors Act (UGMA) accounts, known as UTMAs in some states. Almost all financial services firms offer them, usually with no additional fee.

Contributions to these accounts qualify for the annual gift tax exclusion. All of the firm’s investment options generally are available to these accounts. An adult is listed as the custodian and controls investment decisions and distributions.

Annual income and gains of the accounts are taxed to the child-owner. This is something of an advantage, because the child is likely to be in a lower tax bracket than the parents or grandparents.

A major disadvantage of the UTMA is that under state law the youngster gets full title upon reaching the age of majority, which usually is 18. Then, the child or grandchild is free to spend the account however he or she desires.

Taxable accounts also are an alternative.

With dividends and long-term capital gains taxed at a maximum 15%, the incentive to use tax-advantaged accounts with various restrictions on them is reduced. The parent or grandparent can retain full control over the account, invest it as desired, and control much of the tax burden through investment decisions. Eventually taxes must be paid on gains, but the timing can be controlled. The taxes can be reduced by giving appreciated assets to the grandchild, and allowing the grandchild to sell them and spend the proceeds.

Estate and gift taxes still can be a disadvantage. Annual gifts above the tax-free limit (currently $11,000 per beneficiary) either reduce the lifetime estate and gift tax credit or incur estate taxes. Any amount retained by the parent or grandparent at death is included in the estate.

Prepaid tuition plans but the risk of future tuition increases on the state sponsoring the plan. The plans cover only tuition and fees. Many states suspended their plans or significantly increased costs to cover recent investment losses.