A comparison of college savings plansArticle added by Julius Giarmarco on February 16, 2012
Julius Giarmarco

Julius Giarmarco

Troy, MI

Joined: July 07, 2008

This article will examine the simpler to the more sophisticated college savings programs. For many parents and grandparents, it may be a combination of these strategies that yields the best results.

Planning for college education has become more important than ever because of rising tuition costs. Even those parents and grandparents who can afford to pay for college expenses prefer to do so in the most tax-efficient manner possible. This article will examine the simpler to the more sophisticated college savings programs. For many parents and grandparents, it may be a combination of these strategies that yields the best results.

Tax-free transfers

Amounts paid directly to an educational institution on behalf of a student are not considered gifts. But this exclusion only applies to payments for tuition — not room, board or books. However, those expenses can be covered by the other strategies discussed below. Moreover, such direct gifts only work while the donor is alive.

In PLR 200602002, the IRS authorized direct prepayments to an educational institution by a grandparent for six grandchildren through grade 12. By prepaying the tuition, the donor removes the risk that he/she might die before all the tuition payments are made. But in PLR 200602002, the payments were not refundable. Thus, the payments would be forfeited if a student failed to attend the school for any reason.

Annual exclusion gifts

Every U.S. citizen or resident can gift in each calendar year up to $13,000 (as adjusted for inflation) to a single donee without limit on the number of donees. If the donor is married and his/her spouse elects to “split” the gift with the donor, then the amount can be doubled to $26,000 per donee.

These annual exclusion gifts are free from both the gift tax and the generation skipping tax. Thus, outright gifts of annual exclusion amounts can be made to children or grandchildren who can then use the gifts to pay for college expenses.


A uniform gifts to minors act (UGMA) or a uniform transfers to minors act (UTMA) account can be established for younger children or grandchildren. The exact kind of account will depend on the law of the state of the donor. An exception to the annual exclusion gift rules allows UGMA and UTMA gifts to qualify for the annual gift tax exclusion, even though the child/grandchild received no “present” benefit from the gift (see section on Crummey trusts below).

Similar to a trust, UGMN UTMA funds belong to the minor but are managed by the custodian until the minor reaches a specified age. The age (usually age 18 to 21) depends on state law, and may depend on the type of transfer.
While UGMA/UTMA accounts are simple and inexpensive to establish, they do have several drawbacks. First, the funds cannot be earmarked for college expenses. Thus, upon attaining the termination age, the beneficiary will have complete ability to choose whether to spend the funds on school or not.

Finally, UGMA/UTMA funds will be taxed in the donor’s estate if the donor is the custodian at the time of his/her death. Second, because of the "kiddie tax,” UGMA/UTMA income above $1,700 will be taxed at the parent’s rate until the year the child reaches age 19. The kiddie tax also applies to students under age 24 who do not earn more than half their support.

IRC Section 2503(c) trusts

Named after the Internal Revenue Code section upon which it is based, Section 2503(c) trusts mimic UGMA/UTMA accounts. To qualify, the trust must provide that the property will pass to the minor upon attaining age 21, and that the trust income and principal may be used exclusively for the benefit of the minor before age 21.

Avoiding the need for Crummey powers (see below) is the primary advantage of a Section 2503(c) trust. However, as with UGMA/UTMA accounts, the inability to control the use of funds beyond a certain age is the biggest disadvantage of a Section 2503(c) trust.

The income of a Section 2503(c) trust will be taxed to the trust, unless distributed to the beneficiary in the same year that it is earned. If the income is distributed to the beneficiary, the kiddie tax rules will then apply. However, if structured as a grantor trust, the donor will be responsible for paying the tax on all trust income (until the beneficiary attains age 21). The donor’s payment of this income tax is essentially a tax-free gift to the beneficiary of the trust. After age 21, the beneficiary will be considered the owner of the trust and will be taxed on all of its income.

Crummey trusts

A gift to a trust other than a Section 2503(c) trust normally does not qualify for the annual gift tax exclusion since the beneficiary dos not presently benefit from the gift. However, giving the beneficiary the right to withdraw each addition to the trust changes that result. The right to withdraw can last for as little as 30 days. Of course, most beneficiaries know better than to actually withdraw the gift, but there can be no pre-arrangement to that effect.

A written notice of the beneficiary’s withdrawal right should be sent each time a gift is made to the trust. These withdrawal notices are called Crummey notices, named after the court case that validated this technique.

While Crummey trusts present an administrative burden, they have a big advantage over Section 2503(c) trusts since they can continue well beyond the beneficiary’s 21st birthday. If the beneficiary declines to exercise a withdrawal right, he/she has no later right to receive trust property without the approval of the trustee. Moreover, unlike a Section 2503(c) trust, a Crummey trust can be designed to avoid estate tax in the donor’s and child’s estates.
The income of a Crummey trust is taxed to the trust, unless currently distributed to the trust beneficiary. If distributed, the kiddie tax rules will apply. However, if structured as a grantor trust, the donor will be taxed on all of the income, which is the equivalent of a tax-free gift to the trust’s beneficiaries. But after the grantor’s death, the trust will be treated as a separate taxpayer, and will pay income taxes on any income not distributed.

IRC Section 2642(c)(2) trusts

A grandparent can structure a Crummey trust for a grandchild or more remote descendant so that gifts to the trust (up to the amount of the grandparent’s annual gift tax exclusion) are not subject to the onerous generation skipping transfer tax. Under Internal Revenue Code Section 2642(c)(2), the trust must be for the current benefit of only one beneficiary.

Furthermore, if the trust does not terminate before the beneficiary dies, the assets must be includable in the beneficiary’s estate. An IRC Section 2642(c)(2) trust is taxed in the same manner as the Crummey trust described above.

IRC Section 529 plans

Perhaps the most popular tool today for college savings is the Section 529 plan, named after the Internal Revenue Code section upon which such plans are authorized. Although created under federal law, each state sponsors a plan.

While it is not necessary for a donor to establish a Section 529 plan in his/her own state, some states allow residents to take an income tax deduction for contributions to their own state’s plan.

Among the many benefits of a Section 529 plan are:
    1. The donor can pre-gift five years of annual exclusions per beneficiary (i.e., $50,000 for a single donor and $130,000 for a married donor);

    2. the funds accumulate free of federal income taxes (and in some states, from state income taxes as well);

    3. If used for tuition, room, board and other higher educational expenses, distributions will be totally exempt from federal income tax;

    4. there are no tax penalties if the donor changes beneficiaries; and

    5. the donor can decide to withdraw the funds for his/her personal use subject to the payment of income taxes on the earnings plus a federal penalty of 10 percent of the earnings. However, the penalty is waived if the beneficiary dies, becomes disabled or receives a scholarship.
There are some drawbacks to Section 529 plans. First, only cash contributions are permitted. Second, investment choices are limited to the ones provided by the state plan. Third, there are account balance limitations (of up to $300,000 or more per beneficiary) that vary by state (beyond which further contributions are not allowed).

Fourth, account owners can only make investment selection adjustments or rollovers to a new plan once per year or when there is a change in beneficiaries. Finally, if the beneficiary is changed, the original beneficiary, not the donor, is deemed to have made a gift to the new beneficiary, even though the original beneficiary had no control over such transfer.
Health and education exclusion trusts

While they are alive, the simplest way for grandparents to help with education expenses — and avoid gift and generation-skipping transfer taxes — is to write a check directly to the educational provider (see above). But with a health and education exclusion trust, grandparents can create a legacy by funding tuition expenses for generations to come.

Unlike Section 529 plans, a HEET can pay for tuition at all levels of education, and for multiple generations. Moreover, there’s no limit to how much the grandparents can contribute. Another benefit is that HEETs get around the onerous generation-skipping transfer tax.

There is a GST tax of 35 percent on the amount of a grandparent’s gift to grandchildren that exceeds $5.12 million per person (for 2012). The $5 million gift/estate/GST tax exemption is scheduled, without further Congressional action, to drop to $1 million per person, and the tax rate is scheduled to increase to 55 percent, on Jan. 1, 2013. The GST tax applies whether the gift is made during lifetime or at death.

To escape the GST tax, the HEET must incorporate two features. First, the HEET must make payments directly to the educational provider. The second requirement is that the HEET must have a charity as a co-beneficiary. Otherwise, if the grandchildren were the only beneficiaries of the trust, it would be subject to the GST tax.

HEETs are not based on statutory law, but rather on an interpretation of tax laws. To date, the IRS has not challenged HEETs in court. One gray area is how much of the HEET’s distributions the charity must receive. Many practitioners believe that 50 percent of the trust’s annual income is a reasonable amount. Others give the charity a preset amount each year, subject to a cost-of-living adjustment.

HEETs can also be combined with other plans. Many advisors recommend that clients create both HEETs and Section 529 plans. That’s because a HEET can only cover tuition, while a Section 529 can also be used to pay room and board.

Grandparents can set up a HEET while alive or create one in their will or living trust. In the latter case, a life insurance policy on the grandparents’ lives can be purchased to fund the HEET. If the grandparents fund a HEET during lifetime, they can each put $13,000 per year into the trust for each beneficiary (see above). Any gift that exceeds the $13,000 annual gift tax annual exclusion counts against the $5.12 million per person lifetime gift-tax exemption (for 2012). Beyond that limit, the 35 percent gift tax applies.

Coverdell accounts

A Coverdell education savings account (ESA) can be opened for the benefit of a child under the age of 18 for the exclusive purpose of funding that child’s education expenses. Like a Section 529 plan, ESAs combine tax-free accumulation with tax-free distributions, but amounts withdrawn for other than educational expenses are subject to federal income taxation plus a 10 percent penalty. The penalty is waived under the same circumstances given above for Section 529 plans.

However, there are two major drawbacks to ESAs. First, contributions must be made in cash and cannot exceed $2,000 per calendar year. Second, donor eligibility is subject to income limitations ($110,000 for single donors and $220,000 for married donors).

Life insurance

Another important tool for college savings is life insurance. A life insurance policy will ensure that funds to pay for college education are available if one or both parents die prematurely. And if permanent life insurance is purchased, it will accrue cash values (income tax free) that can be borrowed against (income tax free) to pay for college expenses.

An added benefit of life insurance is that the policy’s cash value is not counted as an asset of the policyholder for federal financial aid purposes (see below). The death benefit will, however, be subject to estate tax in the insured’s estate unless additional measures, such as ownership of the policy by a Crummey trust, are taken.

Financial aid

Most federal financial aid formulas consider about 5 percent to 6 percent of parents’ assets to be available for their children’s college tuition, and 20 percent of a student’s assets. A grandparent’s assets are not considered. Assets in UGMA/UTMA accounts, Section 2503(c) trusts, Crummey trusts and Section 2642(c)(2) trusts are treated as the beneficiary’s assets for federal financial aid purposes.

In contrast, assets in a Section 529 plan established by a parent are treated as the assets of the parent. But if a grandparent establishes a Section 529 plan, the plan is not considered in determining the student’s eligibility for federal financial aid. ESAs are treated the same as Section 529 plans for federal financial aid purposes.


Whatever technique or combination of techniques is used to save for college, it is important that parents and grandparents start their program as soon as possible. Time is a valuable asset. The earlier one starts saving for college, the more time their money will have to grow.

Moreover, each year that a parent or grandparent fails to take full advantage of his/her $13,000 annual gift tax exclusion, the opportunity to shift income taxes and reduce estate taxes is lost forever. Finally, the $5.12 million ($10.24 million for married couples) lifetime gift tax exemption (for 2012) is a terrible thing to waste. By using that exemption sooner than later, the post-gift income and appreciation can be removed from the donor’s estate.

This special report is designed to provide accurate (at the time of printing) and authoritative information with regard to the subject matter covered. It must not be used as the basis for legal or tax advice. In specific cases, the parties involved must always seek out and rely on the counsel of their own advisors. Thus, responsibility for modifying and guiding any party’s action with respect to legal and tax matters is placed where it belongs – with his or her own advisors. Thus, responsibility for modifying and guiding any party’s action with respect to legal and tax matters is placed where it belongs – with his or her own advisors.
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