Deborah Ziolkowski

How to Really Save for College

Tax-free savings strategies revealed.

October 16, 2008
by Deborah Ziolkowski, EA/MST

A college education is an investment that continues to grow more expensive every year. Although financial aid programs offer assistance in the form of grants, scholarships and work-study programs, the majority of financial aid is in the form of loans. Unfortunately, the interest incurred on most of these loans can cost more for the student to attend college, than if the student created a savings plan.

For this reason, it is important to understand the tax-advantaged ways to save for college. A tax-free college savings account can help your clients accumulate more money to pay for college.

Traditional Ways to Save for College

Personal Investment Accounts are a great way to incorporate a college savings plan. Your client’s portfolio provides the flexibility to select individual investments that support their savings goals. As the owner of the account, your client retains complete control over the assets. In addition, they can make unlimited contributions to their account. However, when assets are sold, earnings are taxed at your client’s marginal-tax rate or capital-gains rate, depending on how long the investment has been held.

Custodial Accounts are set up under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). This account allows your clients to make irrevocable gifts to minors in the form of cash or securities. Income generated from the custodial accounts is subject to a “kiddie tax.” In addition, the custodian retains control over the account until the child reaches legal age, which generally is age 21. However, at legal age, the child will gain control of the account and may use the funds at his or her discretion. Any withdrawals made before the child reaches legal age must be used for the benefit of the child.

Tax-Free Tips to Save for College

Yes, there are such options. Below are a few strategies tax practitioners can suggest to their clients.

Coverdell Education Savings Accounts (ESA). The Coverdell ESA allows contributions of $2,000 per year, per beneficiary. However, investors must meet certain income limitations to be eligible to make contributions. For example, to make a full contribution, (Single AGI) up to $95,000 and (MFJ AGI) up to $190,000.

Coverdell Distributions. Accumulations on contributions to a Coverdell ESA are not subject to federal income tax while they remain in the account. When distributions are used for a qualified expense, at an eligible educational institution, they are free of federal income tax (IRC Sections 530(b)(2), 530(b)(4) and 530(b)(3)). If a distribution is taken from a Coverdell ESA and is not used for a qualified expense, the portion of the distribution representing earnings is subject to ordinary income tax and subject to a 10 percent federal penalty.

Qualified expenses generally include: tuition, books, supplies, equipment, room and board, special needs services, transportation and computer, software or Internet services.

Beneficiaries designated as having special needs can maintain a Coverdell ESA indefinitely. In all other cases, assets may remain in a Coverdell ESA until the beneficiary reaches age 30. At that time, the beneficiary has three choices:

  1. Remove the balance by taking a nonqualified withdrawal.
  2. Roll the balance into a 529 plan.
  3. Roll the balance into the Coverdell ESA of another family member.

Finally, for federal financial aid purposes, assets in a Coverdell ESA are considered assets of the account owner, or parent, in most instances. Federal financial aid formulas generally expect parents to use 5.6 percent of their assets to send their child to college. Therefore, using the Coverdell ESA as a college funding vehicle will be more advantageous from a federal financial aid perspective than saving in a custodial account.

529 Plans. Section 529 plans are state-sponsored plans to encourage residents to save for college. Passed in 2001, EGTRRA allows federal income tax-free withdrawals from 529 plans for qualified higher education expenses. This generally includes tuition, books, supplies, equipment and room and board. However, withdrawals for expenses other than qualified education expenses, may be subject to federal and state taxes and a 10 percent federal penalty. The 529 plan also provided special estate and gift tax treatment for participants. Since 2002, 529 plans have become the college savings plan of choice.

529 Plan Contributions. Anyone, regardless of age or income, can make contributions to a 529 plan on behalf of a beneficiary. However, there are three limitations relating to contributions to a 529 account:

  1. Gifting Limit — Because Section 529 does not impose an annual contributions limit on 529 plans, contributors need to be aware of the federal gift exclusion defined in IRC section 2503(b). To avoid gift tax and reductions in the lifetime gift exclusion, contributors may take advantage of the annual gift exclusion of $12,000 per beneficiary of a 529 plan.
  2. Special Gifting Provision — IRC Section 529(c)(2) allows a special gifting provision that is not available in any other estate-planning vehicle. A contributor may “front load” the gift by contributing five years of annual gifts in one year, or contribute $60,000 on behalf of a beneficiary to a 529 plan in one year. (The contributor would need to file IRS Form 709 when using this special gifting provision).
  3. Account Limit — Because the intended purpose of a 529 plan is to provide a way to save for college, account limits are applied to prevent accumulating more money than is needed to send the beneficiary to college. The account limit varies by state but is generally in excess of $225,000.

Although 529 plan contributions are not deductible from federal income tax, some states provide a deduction or credit for residents who participate in their state’s 529 plan. Unfortunately, California does not have a deduction or credit for a 529 plan.

529 Plan Distributions. Accumulations on contributions to a 529 plan are not subject to federal income tax while they remain in the account. When distributions are used for qualified higher education expenses at an eligible educational institution they are free from federal income tax and, in most cases, state income tax as well.

Estate Strategies With 529 Plans. Contributions to a 529 plan are considered gifts, the assets are removed from the contributor’s estate. Another unique feature, the account owner maintains control of the account for the life of the account. This control, coupled with the special gifting provision, makes use of a 529 plan a viable strategy for those who want to leverage their estates to help send a child to college.

Additional 529 Plan considerations are as follows: the balance in a 529 plan can be rolled to another beneficiary if that person is a family member of the original beneficiary. Investments within the 529 plan are considered municipal securities. Finally, the account owners of 529 plans cannot directly or indirectly direct the investments within the plans. For this reason, investments in a 529 plan must be managed by the state. Account owners are entitled to change their investment options only once per calendar year without a change in the beneficiary.


Saving for college using the above tax-advantaged methods, such as the Coverdell ESA or a 529 plan, can help your clients meet the rising cost of a college education.

CPAs and tax practitioners should note that the IRS will clamp down on 529 plans for 2008 and issue regulations that will target abuses, such as putting as much as $120,000 (the maximum 529 pay-in that’s free of gift tax) into accounts for different people, then quickly changing the beneficiary on all of the accounts to one individual. Another ploy is to put a lot of money into a 529 plan and later using the funds to pay for retirement. This allows contributors to circumvent the pay-in ceilings and distribution requirements that apply to qualified retirement plans.

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Deborah Ziolkowski, MST, received her Master’s of Science in Taxation from Golden Gate University and has her Tax and Accounting practice in Sausalito, California. She has been a tax professional for 12 years.