You have a number of options when it comes to saving for college. There are Uniform Transfers to Minors Accounts, education IRAs, and prepaid tuition plans, just to name a few. All the options have their advantages, but have you considered a 529 account?
A 529 account combines great features to make a fairly good investment vehicle. The main advantage is that the earnings and most withdrawals are income tax free. Even though you must use after-tax money to create the accounts, all capital gains, dividends, and interest are generally tax free. Withdrawals are subject to income taxes only when they are not used for tuition, room, board, and other authorized expenses. Another advantage is that gifts to a 529 account not only qualify for the $13,000 annual gift tax exclusion, but you can even make five years worth of gifts today and elect to treat them as being made equally over a five year period. For example, a married couple with four grandchildren can give as much as $130,000 to each grandchild right now for a total of $520,000 to the four grandchildren. Each grandchild will be treated as receiving $26,000 per year for five years.
As far as estate taxes are concerned, all amounts you contribute to the account will be excluded from your estate even though you are the person controlling the account. However, if you elect to spread your contributions over five years for gift tax purposes and you die within that five year period, a portion of the gift will be included in your gross estate.
There are a few downsides worth noting. Unlike some of the other alternatives available for saving for college, 529 accounts don’t let you choose the investments yourself. All you can pick is the type of investment portfolio the account will maintain. Also, if you use funds in the account for non-qualified purposes, a 10% penalty will apply to the portion of the withdrawal which constitutes investment gains.
Overall, 529 accounts present you with an unbeatable combination of features. The accounts offer income tax free growth and withdrawals with no gift taxes, no estate taxes, retained control of the funds, and flexibility in the future should circumstances change.