Saving for college: What are your choices?
When saving for your child’s college education, one size does not fit all. Should you choose a Coverdell Education Savings Account or an UGMA/UTMA custodial account in your child’s name? Or would you prefer to simply put money into an account in your own name? Ideally, you will want to choose a savings vehicle that offers the best mix of tax advantages, financial aid benefits, and flexibility while meeting your overall needs.
Azzad offers the following types of accounts that you can use to save for education expenses. Our financial advisors can help you decide which one is right for your family.
Coverdell Education Savings Account
A Coverdell Education Savings Account (formerly Education IRA) is a tax-advantaged educational savings account that you can establish for any child under age 18. Withdrawals can be used to pay for qualified college, secondary or even elementary school expenses. Contributors must meet certain income eligibility requirements.
- Withdrawals for qualified expenses are generally tax-free
- Tax-free growth until funds are withdrawn
- Flexibility of education expenditures
- Ability to change the designated beneficiary to another qualified family member
- Continue to manage the account even after your child reaches majority age
Potential disadvantage: Income restrictions exist for depositors into a Coverdell account.
UGMA / UTMA Custodial Accounts
An UGMA/UTMA custodial account can be used to save for college or anything else that benefits your child. (The acronyms stand for Uniform Gift to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA).
With these accounts, a custodian (usually a parent) manages the account, but its assets are considered an irrevocable gift to the child.
Before opening an UTMA account for your child, make sure you know the pros and cons to avoid any regret later.
An UTMA account can offer several advantages, including:
- More investment options than Section 529 accounts, including halal and socially responsible investments. As the custodian, you control how the account is managed on behalf of the child until the child reaches the age of majority.
- High annual gift limits.
- Flexibility to use funds for anything that benefits the child, including pre-college education or non-education related expenses.
- A small tax benefit by shifting some annual investment income to a child’s lower bracket.
- Ability to shift wealth to a child over time without incurring gift or estate taxes.
However, you should also be aware of potential disadvantages of an UTMA account:
- If you think your child may qualify for needs-based financial aid, an UTMA account could hurt their chances. Custodial assets count more heavily against a student’s financial aid application than parental assets, since they are considered an asset of the child. Of course, this should not affect merit-based financial aid.
- Contributions to an UTMA are considered an irrevocable gift to a child. That means you cannot take the contribution back nor can you transfer that money to another child. Any funds placed into an UTMA account must be used for the benefit of the named child.
- An UTMA requires a custodian to give control of the assets to the child between ages 18-21, depending on the state. A strained relationship between a child and custodian could pose a problem in finding agreement on how the assets should be used.
We invite you to contact an Azzad financial advisor to find out which savings options will fit best with your family’s needs and goals.
How new tax law affects savings in a child’s name:
With the Tax Cuts and Jobs Act of 2018, the kiddie tax has been simplified and will stay in effect until 2025. As in previous years, a child is allowed $2,100 in untaxed, unearned income. Amounts over the $2,100 threshold are taxed at the following rates:
Up to $2,500: 10%
$2,551 to $9,150: 24%
$9,151 to $12,500: 35%
All over $12,501: 37%
The good news is that kids are no longer affected by their parents’ tax rate. Plus, parents no longer have to worry about adding the earnings of several siblings together.
Be careful because the new rates could be higher than a parent’s highest tax rate under the new tax code. However, a married couple would have to have over $600,000 in income to reach the highest kiddie tax rate of 37%.
Example: In 2017, a child has unearned income of $5,000. They would have paid 0% on the first $2,100. Then on the remaining $2,900, they would pay $1,148 in taxes if the parent’s tax bracket was 39.6%.
In 2018, a child who has that same amount in unearned income would again pay 0% on the first $2100. The tax would be 10% on the next $2,500 or $250 and then 24% on the remaining $400 or $96. That’s a tax bill of $346 under the new law, compared to $1,148 in 2017.