CountingBean

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A capital investment is defined as money paid to purchase a capital asset (and a capital asset is any asset that makes you money).

I think of myself as a capital asset. As a matter of fact, my parents have been telling me this all my life.

Flashback to JoAnn’s college years:

Me: “Guess what? I learned all about different types of investments such as stocks, mutual funds, and the appropriate asset allocations for different demographic groups. What do you and dad invest in your retirement plan?”

Mom: “Aww… that’s cute honey. You are our retirement plan.”

Clearly, my parents didn’t feel any compunction about treating their children as potential income streams for the future. It’s the same reason they never bought a remote control TV when we were growing up. Why buy a remote control when you can have your kid turn the channel?

But anyhow, if you are going to treat your offspring as capital assets, then you should probably invest in their education. After all, the more money they make, the more likely you won’t be eating cat food in the future.

Through my random research and fact gathering, I found that there’s three primary savings account types that’s most commonly used. Typically called Registered Education Savings Plan or R-E-S-P(-e-c-t… Find out what it means to me… sock it to me… sock it to me… ). Sadly, none of these are tax-deductible, but they do show their benefits in other ways…

1. UGMA/UTMA (Uniform Transfer/Gift to Minors Act)

UGMA/UTMA accounts are custody accounts where the minor owns the assets in the account. A custodian (typically the parent) is designated to perform transactions (such as investing or withdrawing money) for the minor. Once the minor turns 18-21 years old (depending on their state), they then take control of the account for themselves.

Pros:

The money in this type of an account can be used for anything, it’s not limited strictly to educational expenses (use with great caution if junior would prefer a new mustang rather than attending State University). Also, there’s no minimum or maximum contribution limits (although you may want to consider federal gift-tax exclusion limits if you have several thousand dollars to put in) .

Cons:

This account is factored heavily when a minor applies for financial aid. Also, the account does not grow tax-free (but it may be able to take advantage of the reduced “kiddie-tax”, provided that your yearly earnings on this account remains low).

2. Coverdell (formerly called Education IRA)

Coverdell is an Education Savings Account. A Coverdell is an account specifically used for education (elementary through college). The assets in the account legally belongs to the minor (the beneficiary), but similar to the UTMA/UGMA, you have a custodian perform transactions.  In order for a withdrawal to be tax/penalty free, it has to be considered a “qualified education expense”. These are expenses that are necessary for the enrollment or attendance of the minor at an eligible institution (such as tuition, books, supplies, etc). According to the IRS Publication 970, “An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.”

Pros:

The earnings on the account is tax free when used for education. Another advantage of this account is that it’s not limited to college expenses. If junior decides to go to a vocational school, the expense may still be able to qualify. Since this asset legally belongs to the minor, these aren’t as heavily factored in applying for financial aid since it’s counted as the parent’s assets.

Cons:

There is an annual contribution limit of $2,000. Also, when you set this account up, there is typically a yearly custody fee of approximately $10. This means that if you’re contributing a small amount for the year (ie, $500 or less), then the custody fee could significantly impact your rate of return. There’s also a time restriction. You can keep contributing to the account only until the minor reaches 18 years old, then the funds have to be spent before they reach 30 (otherwise, it may be subject to penalties). Another caveat is that your contribution is subject to your Modified Gross Adjusted Income (MAGI). For 2010, it phases out at $95K-110K for single filers and $190-220K for joint filers. 

3. Section 529 Plan (aka QTPs- Qualified Tuition Programs)

A 529 Plan is an education savings plan operated by a state or educational institution to help set aside funds for future college costs. There’s two types of 529 plans: Prepaid and Savings. Prepaid plans lets you purchase the cost of a college education using today’s dollars, to be used in the future, while Savings plans functions like the Coverdell in the fact that you can contribute and let the account grow tax free when used for eligible college expenses.

Pros:

Prepaid plans allow parents to lock in the tuition rate at today’s prices. For example, if they pay for 50% of the tuition today and junior decides to go to college after ten years. Even if the tuition fees double by the time he goes to school, their child still has 50% of their college education already paid. Savings plans allows contributions to grow tax free. Another advantage of the Savings plan is that anyone can contribute money on behalf of a beneficiary and still retain legal ownership of the assets. The donor will continue to control the account until all the money is depleted. This is different from the above two accounts since those assets legally belong to the minor. This is especially important since there’s no yearly maximum contribution or income limitations on this type of college savings account.

Another benefit is that the beneficiary designation on these accounts are transferable to other qualified members of the beneficiary’s family. This allows for greater flexibility if junior decides to become a rock star, then you can easily transfer the money to his sister who’s an aspiring doctor. You can consult Publication 970 from the IRS website for a complete list of “qualified relatives”.

Lastly, there’s no age restrictions on when to use this money. If junior decides to take a 10 year break to go “find himself” while back packing in the Himalayas and decides later that he wants to be a global scientist specializing in quantum physics, then the money is there for him to use. It’s not like the Coverdell that’s restricted to the age of 30.

Cons:

Not all states offer Prepaid plans. Also, the redemptions are more restrictive in the sense that you can only use these assets to pay for a college education (no elementary tuition fees or vocational schooling). If you don’t use it for eligible college expenses, then you have to pay income taxes and a 10% federal penalty on earnings. You may be subject to state tax penalties as well.

Also, a huge drawback is that you’re allowed only one exchange or re-allocation per year. Invest wisely, because you’re pretty much stuck with your choice for a year.

Although some folks use their state’s 529 plan for tax deductions, you can actually invest in a state plan that’s different than the state you reside in. This is an important consideration if other state plans have a higher yield and lower expenses than your own state plan.

So there you have it… If you’re like my parents, you’ll think of college savings plans as a way to secure your future. If not, then even if your kids don’t end up supporting you, with a college degree, at least you won’t end up supporting them.

P.S.= If your kid is taller than Yao Ming or is blessed like the model Gisele, then party on. This article applies to mere mortals.