Tough choices for funding college tuition

funding collegeWith tuition costs increasing significantly each year, paying for college gets further out of reach for most parents. Public or state institutions often provided a more affordable alternative to private schools that were thought of as more expensive.

However, with reductions in funding, state tuition costs are on the rise. In fact, according to State Higher Education Executive Officers Association, the average public college tuition increased 8.3 percent.

Parents saving and investing for their children’s future college costs would have to earn 8.3 percent net of fees just to keep pace with the jump in prices. Tuition inflation at both public and private schools continues to rise and parents who hope to provide a college education for their children must get started as soon as possible.

Once you decide you are ready to save for college, the next question becomes where to save? While parents are often forced to rely on student loans and home equity as options to pay for college, 529 plans and custodial accounts are usually considered for those who have time to save in advance. Due to the differences in tax treatment and financial aid effects, it is critical to understand the pros and cons of each savings strategy before getting started.

Custodial accounts

Custodial accounts, often referred to as UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfer to Minors Act) accounts, are options that families can utilize to save for college costs for minor children. The parent or grandparent is often the custodian and is responsible for managing the investments. Although all funds eventually withdrawn from the account are required to be used for the benefit of the child, they do not necessarily have to be used for college.

Custodial accounts were used in the past as a way to move money from the parent’s higher tax rate to the child’s lower tax rate. The IRS quickly caught on and developed the “Kiddie Tax,” which eliminates many of the tax benefits of the custodial account. Currently, the child does not pay tax on the first $1,000 of interest income in the account while the next $1,000 of interest income is taxed at the child’s rate of 15 percent.

However, any income above $2,000 will be taxed at the parent’s rate. This means that any significant income and its associated tax liability will be bounced back to the parent if it is greater than $2,000.

It is also important to note that the assets in an UTMA are considered an asset of the minor child. Once children reach the age of majority (21 in New Jersey), they have control over the asset and are free to spend it as they see fit. If you are not comfortable with your 21-year-old having access to funds to purchase a sports car that were intended to be spent on college, you may need to look at other savings alternatives.

Additionally, custodial accounts are considered an asset of the child for financial aid purposes which may lead to less financial aid being awarded than if the asset were in the parent’s name. Custodial accounts provide flexibility, but at a cost – taxes, lack of control and possible reductions in financial aid.

529 Plans

529 plans were designed specifically for college funding and can be one of the most effective ways to build savings. Unlike custodial accounts, which are taxable depending on income and capital gains, funds used for qualified education expenses from a 529 plan grow federally tax-free.

That’s right — no federal income tax. However, the funds must be used for qualified education expenses, otherwise a 10 percent penalty and tax on the gains will be levied on the account. Keep in mind that tax treatment on the state level may vary.

Additionally, 529 plans are considered an asset of the parent for financial aid purposes, which may be to your advantage — possibly leading to more financial aid than maintaining a custodial account. Each state has their own plan and many offer additional incentives for saving including tax deductions on contributions.

While the state of New Jersey does not offer tax deductions on contributions, residents who choose to use the NJ 529 plan may qualify for a small scholarship of up to $1,500 for their freshman year if they remain a state resident and choose a college or university here.

Although you may lose the small scholarship opportunity, you are not required to use the NJ 529 plan and have the option to save within any state plan. The decision of which plan to use will be based upon each plan’s features, benefits, investment options and fee structure. Also be sure to consider whether the investor or beneficiary’s home state offers any state tax or other benefits that are only available for using their state’s plan. Speak to your tax advisor and visit for a comparison of 529 plans.

As costs continue to rise, providing for a child’s college education becomes more challenging. While custodial accounts and 529 plans are two savings options, there are additional alternatives available. Consider speaking to your tax and financial adviser to determine the right approach for your unique circumstances.


Kurt J. Rossi, MBA, is a Certified Financial Planner practitioner and wealth adviser. He can be reached for questions at (732) 280-7550 and LPL Financial Member FINRA/SIPC.