There are a different college savings options for wealthy families, but confusion abounds about what path is the right one. In particular, for high net worth parents and grandparents, providing for a college education to the next generation, while balancing taxes, moral hazards (kids having access to too much money), risks and controls, and wealth transfer is an essential financial planning consideration.
Most wealthy families believe education is one of the most significant gifts they can bestow on their kids, grandkids, and other younger relatives. And most HNW families have access to the resources to help, but planning is essential for many reasons:
- Early planning gives the time horizon for assets to grow while withstanding volatility.
- Taxes are a significant consideration, and hence planning helps to formulate an effective tax strategy.
- As the prudent among us know, having wealth and resources today is not a guarantee of the same way in the future. The economic downturn, wrong decisions, bad luck, litigation, and other factors can diminish the wealth and constrain the ability to provide for heirs’ college education.
- Saving early, often, and enough helps reinforce the love and generosity of the grantors but also may provide peace of mind for the intended recipients.
College Savings Options for Wealthy Families:
UGMA/UTMA Custodial Accounts:
UGMA and UTMA are perhaps one of the oldest and easier ways to transfer assets to children. UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) allow parents and others to set up a custodial trust for the benefit of the minors. UGMA and UTMA are similar except for one big area – the type of assets a grantor may contribute to the custodial trust. The UTMA is a more expansive trust allowing a range of others that are not permissible under UGMA – such as inheritance, real estate, fine art, patents, and royalties, etc.
Unlike other trusts, UGMA/UTMA do not require the services of an attorney to create a custom trust document but are based on state statutes.
To transfer money or other permissible assets – based in fact whether it is a UGMA or UTMA and the state statute – a person can establish a custodial trust by transferring assets and naming a beneficiary. The custodial trust is held in the name of the minor and the trust needs a Custodian until the minor reaches either age 18 or 21 depending on state statute. The Custodian acts in a fiduciary capacity and must conduct the affairs of the trust to benefit the minor.
Technically, there are no limits as to how much one can contribute a UGMA or UTMA. However, any amount that is over the annual gift tax exclusion limit is subject to federal gift tax. For the tax year 2018, that limit is $15,000, and for 2019 the threshold is not yet determined. However, if the donor is willing to pay gift or estate transfer tax, they can deposit as much as they want.
The donor typically acts as the custodian or appoints a custodian. The custodian is a fiduciary and will need to act prudently in the best interest of the child.
The earnings in the UTMA/UGMA accounts are also subject to income tax. There is an exclusion of up to $2100 in 2018, and then the earnings are taxable. If the gains are below $10,500, the parents may elect to file it on their tax return. Please review IRS rules for specific guidance and please consult your tax advisor.
The UGMA/UTMA accounts do not offer tax-deferral, and also the withdrawals are taxable (over and above the original contributions by parents/grandparents and other interested parties.)
There is no limit on withdrawals, and also there is no limitation of the purpose of why the money is being withdrawn.
Another thing to be aware of is when the junior reaches either 18 or 21 (based on state laws), the money belongs to them. So, they can do anything with that money – not just spend on education, but also potentially buy a car, plane, or designer clothes.
529 C College Savings Plans:
The 529 C College Plans are a result of the Section 529 C of the IRS internal revenue code (IRC). There is a lot of information on 529 C plans, and typically they are an excellent vehicle for tax-deferred growth and tax-free withdrawals for qualified purposes.
The 529 C plans come in two flavors – A College Savings Plan and a Pre-Paid Tuition Plan. A college savings plan allows donors to contribute periodically or in lumpsum money toward K-12 education or college. A pre-paid tuition plan provides for pre-paying all or a portion of the in-state tuition cost for college at a state/public university. (There are rules on how to convert these accounts to pay for out-of-state tuition or even a private college.)
Each state offers its own 529 C plan with a variety of features and investment options. A state may provide both the pre-paid plan as well as the college savings plan. However, an educational institution can only offer a pre-paid tuition plan.
The contribution limits to the 529 C plans can be as high as $380,000 thousand, but this may incur gift tax. Or if you want to leverage the annual gift tax exclusion, there is a provision to contribute up to $70,000 to cover 5-years of contributions.
Parents/grandparents and other donors are not limited to any particular state plan even though each state may offer its residents incentives to choose their plan. So, if you live in New York, but open an account in Massachusetts (assuming the junior will follow the family tradition of going to Harvard), but when the time comes the youngster goes to University of California, Berkeley, you may still be able to use the 529 C college savings plan. (Rules may be different for conversion of a pre-paid tuition plan.)
The withdrawals can only be for qualified educational expenses and this cover a wide swath including room and board, computer equipment, as well, of course, the tuition.
Coverdell ESA (Education Savings Account):
Coverdell ESA (Education Savings Account) is an excellent option if you qualify. The current IRS rules state that if the combined annual household income is less than $190,000, one can make the entire $2000 in annual contributions and the amount is phased out at $220,000.
As most HNW families’ income may exceed this amount, there is a way to fund the ESA accounts – by gifting your child some money and then they can support the ESA account.
Coverdell ESA contributions are made with after-tax dollars (similar to a Roth IRA), and the amount inside the ESA grows tax-deferred. And the withdrawals for qualified educational expenses are tax-free.
The main challenges for Coverdell ESA accounts are the low contribution limit and the income phase-out. However, the tax-deferral and tax-free withdrawals are worth considering.
Trusts are one of the most trusted vehicles for wealthy families to codify their desires, covenants, and guidance into a legal framework that can be enforced long after they are gone. Trust is like a blank canvas, and within the IRS rules and regulations, one can be as creative as possible.
Typically, the trust laws are governed by state statutes and will usually need an attorney to draft the trust documents.
There are numerous advantages, particularly to wealthy families, to setting up educational trusts.
- The trust reflects the real intent and desires of the donors
- The grantor/donor can specify the very particular terms and conditions (within allowable rules and regulations)
- There is no limit to the monies or the types of assets that one can contribute to the trust.
- The grantor can exercise control as the initial trustee and then appoint a successor trustee.
- There is no limit to withdrawals or purpose as long as the withdrawals are consistent with the terms of the trust and within the legal framework.
The disadvantages of trusts are that they are expensive to create and manage. And any amount that exceeds the annual gift tax exclusion is subject to estate/gift taxes.
When the time comes to write a check:
Of course, the advantage of being a wealthy family is that there are resources to write a check at the time the kid is college bound. There is nothing like the ability to write a check for $75,000 a year to cover for tuition, room, board, and other expenses.
But the negative is no one know what the financial situation will be 10-12-15-18 years hence.
Let’s look at the overall Pros and Cons of these various instruments for college:
|Comparison of College Savings Options for Wealthy Families|
|Vehicle||Coverdell ESA||529 C Plan||Trust||UGMA/UTMA|
|Description||After-tax dollars grow tax-deferred, and withdrawals are tax-free for qualified purposes.||After-tax dollars grow tax-deferred, and withdrawals for qualified educational expenses are tax-free||After-tax dollars with enormous flexibility in structuring the educational trust||A custodial account with post-tax dollars in the name of the child, after that attaining majority, they (the kids) own the assets|
|Contribution Limits||$2000 per child per year from all sources with phasing out based on income||High limits with some plans going up to $380,000.||No limits.||Technically no limit, but anything above annual exclusion is subject to gift tax.|
|Withdrawals||Withdrawals for qualified expenses||Withdrawals for qualified educational expenses||No limits on withdrawals and no limitation on purpose||No restrictions on withdrawals and no limitation on purpose|
|Tax Consequences||After-tax contributions, tax-deferred growth, tax-free withdrawals||After-tax contributions, tax-deferred growth, tax-free withdrawals||Ongoing gains are taxable to the trust on an annual basis. Disbursements are taxable at the beneficiary level.||Income below $2100 is excluded. And up to $10,500 may be included in parents taxes.
Ongoing taxes, as well as withdrawals, are taxable (over and above the principal+ gains on which taxes are already paid.)
Criteria and considerations for formulating a college savings plan
- What is your (or family’s) goal with regards to education of children/grandchildren and other minor relatives?
- How much stability do you foresee with regards to your wealth status?
- Are you concern mainly about tax-deferral and tax-free withdrawals?
- What is your mindset about control of the assets?
- Do you want to take advantage of the annual gift tax exclusion?
- What are your risk tolerance and time horizon?
- Do you foresee the beneficiary going to college and using the funds for qualified educational expenses?
A Prudent Plan for College Savings for Wealthy Families:
It depends on each family’s financial situation and the goals and objectives, but here is a prudent plan.
- Use the gift tax exclusion to transfer $2000 per child and invest into Coverdell ESA (that is the child is contributing the amount)
- Consider a UTMA/UGMA account if you are not able to justify the expense for the Trust. If it is an option between UTMA/UGMA custodial accounts and 529 C plans, the latter is a better option. However, if you are unsure your child will go to college and have qualified educational expenses and you trust the child to do the right thing when they attain majority (age 18 or 21 based on the state), then UTMA/UGMA custodial accounts may be OK.
- Leverage the balance of the annual exclusion to invest into 529 C plans.
- Create a Trust for any additional monies you wish to grant to your beneficiaries and define the terms of the trust based on your wishes
So, these are the College Savings Options for Wealthy Families to consider for funding their kid’s education.
The IRS rules and state statutes change often and hence please make sure you have the latest information. The information in the article College Savings Options for Wealthy Families is for informational purpose only and please consult your tax, legal, and financial advisors to tailor a plan for you. No strategy is good or bad in its own right; it depends on your situation and preferences.