If you’re saving money to pay for a child or grandchild’s education, the new federal tax law includes some tricky rules and opportunities that you need to know about. But proceed with caution—the new rules can be difficult to interpret and contain some ­potentially costly gotchas…

529s for Elementary Tuition

Money invested in a 529 college savings plan, a form of tax-advantaged account, now can be spent on kindergarten through high school (K–12) tuition without triggering federal income taxes or penalties upon withdrawal. Previously, withdrawals from a 529 were tax- and penalty-free only when used for college expenses. Of course, ­using money saved for college to pay for precollege education means a shorter ­period of tax-free investment growth and a smaller college fund. But if you still want to use 529-plan money for K–12 education, be aware of these three less obvious traps…

There could be state taxes and penalties. Most states likely will adjust their tax codes to allow tax-free withdrawals from 529 plans now that the federal government has done so…but that might not happen this year. Contact your state’s 529-plan administrators to confirm that there won’t be state-tax consequences before using 529 money for K–12 tuition.

Not all K–12 costs qualify. You can spend 529 savings on a wide range of college costs, including tuition, room and board, textbooks and activity fees. But when it comes to K–12 costs, only tuition qualifies. Also, K–12 tuition withdrawals are capped at $10,000 per year per student.

Some kids could lose their K–12 scholarships. If you have significant assets in a 529 plan and your child receives (or hopes to receive) a need-based scholarship from a K–12 school, that scholarship might soon shrink or disappear. Most K–12 private schools have historically not factored 529 savings into their calculations when they decide which students and prospective students qualify for need-based aid. But many of these schools likely will start doing so now.

Helpful: Private K–12 schools are unlikely to consider 529 savings in accounts owned by grandparents even if those 529s name the grandchild as beneficiary. To this end, grandparents who want to help save for college could open a 529 account themselves, rather than contribute money to a 529 account opened by the parents. To maximize long-term investment gains, this account could be opened before a grandchild is born, naming a grandparent or other family member as beneficiary. Then change the beneficiary to the child once he/she is born and has a ­Social Security number. (Grandparent-owned 529s can have implications for college financial aid, but there’s a way to avoid this—see below.) While you can have one 529 account and use it for multiple grandkids, it’s almost always easier to set up a separate account for each student—a 529 plan can have only one beneficiary at a time, so it can get complicated if there are two grandkids in college at the same time. Plus, the annual contribution limit is per beneficiary, so having separate 529 plans lets you save much more.

New “Kiddie Tax” Rates Could Affect College Savers

Accounts known as UGMAs (Uniform Gifts to Minors Accounts) or UTMAs (Uniform Transfers to Minors Accounts) are alternatives to 529 plans. UGMAs/UTMAs do not provide tax-free investment growth as 529s do, but there are no penalties if UGMA/UTMA savings are used for something other than education. And investment profits from an UGMA/UTMA are considered income for the child, not the parent—a distinction that can lead to low tax rates, thanks in part to the new tax law.

Here’s why: Prior to 2018, children’s investment income above $2,100 was taxed at their parents’ top marginal tax rate—this prevented parents from avoiding taxes by stashing their own investments in the names of their kids. For most families, that top marginal rate was between 15% and 28%, but it could have been as high as 39.6% for high earners. But under the revised “kiddie tax” rules that took effect in 2018, investment income above $2,100 in a child’s name is taxed at the rates that apply to trusts and estates—the parent’s tax bracket is no longer a factor. (These rules apply to children younger than age 19…or younger than age 24 in the case of full-time students with limited earned income.)

That change will result in very low taxes on UGMAs/UTMAs as long as the child has no more than $4,650 in unearned income each year. After the $2,100 threshold is met, the child’s next $2,550 in unearned income now is taxed at a modest 10% rate. Rates climb quickly after that (first to 24%, then to 35% and finally 37%), limiting the appeal of larger UGMAs/UTMAs, but the low tax on up to $4,650 in annual unearned income does hold some appeal. Despite this, there are three things worth knowing before you put money in an UGMA/UTMA…

529 plans still offer the superior tax deal—usually. Modest annual income from an UGMA/UTMA might now trigger only minimal taxes, but 529 investment profits generally are not taxed at all. UGMAs/UTMAs come out ahead from a tax perspective only if the money is not spent on qualifying educational expenses.

UGMA/UTMA savings are out of your control. Money you put in a 529 account still is legally yours. You could even change the account’s beneficiary if you liked. When you put money in an UGMA/UTMA, it belongs to the child. When that child turns age 18 or 21 (this varies by state), he can spend it however he likes.

UGMAs/UTMAs can cost you financial aid. UGMAs/UTMAs are legally owned by the student—and the more assets a student owns, the less financial aid he is likely to receive. A 529 account has a much smaller effect on financial aid because it is legally owned by the parent.

Helpful: Assets in a 529 account owned by a grandparent are not included in college financial-aid calculations. But when those grandparent-owned 529-plan assets are withdrawn and used to pay a student’s educational expenses, that counts as income for the student—which could reduce aid. To avoid this, do not tap grandparent-owned 529s until after January 1 of the student’s sophomore year, if possible. Financial-aid decisions are based on a family’s finances during the “prior prior year.”

When a Coverdell Education ­Account Is Better Than a 529

Until 2018, a tax-advantaged savings vehicle known as a Coverdell Education Savings Account had two notable advantages over a 529 a­ccount. One was that Coverdell money could be spent on K–12 costs, not just college costs, without triggering taxes or penalties—but now 529 accounts can do that, too.

The Coverdell’s second advantage was that it does not restrict savers to a limited menu of investments as 529s do—Coverdell accounts typically offer a broad range of investments and let owners change their investment choices as often as they’d like. That advantage remains, although investment choice usually is not a problem for 529 account holders because most 529 plans have a good selection of investment options. But if you want greater control over your investment choices, that could be a reason to invest in a Coverdell. And Coverdell funds can be used for a wide array of education costs for K–12, with no annual dollar limit on disbursements (not just tuition). When considering a Coverdell, here are three limitations worth knowing about…

Coverdells have low contribution limits. You cannot contribute more than $2,000 per year per beneficiary. In contrast, annual contributions to 529 accounts are virtually uncapped. (Total 529 contributions are capped in some states, but rarely below $235,000 or $300,000 per student.) Note that you can contribute to both a Coverdell and a 529.

Coverdells have income limits. You’re not allowed to make the full contribution if your modified adjusted gross income is above $95,000 ($190,000 if married and filing jointly)…and you cannot make any contribution if it is above $110,000 ($220,000 if married and filing jointly). There are no income caps with 529s.

Coverdells have age limits. Contributions are not allowed after the beneficiary turns age 18…and the money generally must be withdrawn within 30 days of the beneficiary’s thirtieth birthday. There are no age restrictions with 529 accounts.

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