What are the basics on ESAs, educational IRAs, 529s, and UTMAs?
The Educational IRA is the same thing as an ESA (Educational Savings Account). The ESA is basically buying a mutual fund and stamping it ESA. You must make less than $200,000 annually (married filing jointly). You can contribute up to $2,000 annually per child. You can have several ESAs, but the total of them can only be $2,000 annually per child. That money will grow completely tax-free when used for higher education. You can move them around to different mutual funds as well.
Like ESAs, 529 plans all grow tax-free, but you have significantly less control than with an ESA.
There are three kinds of 529 plans.
The first is pre-paid college tuition. NEVER do this. The rate of return is based on the inflation rate, which is currently around 7 percent. This is a terrible rate of return for a long-term investment.
The other types of 529s allow you to invest up to $10,000 annually. With the Life-Phase 529, you give the money to a 529 administrating company, and they invest it based upon your child's age. You have no control over where they invest. They will be very conservative, and will usually yield an 8 to 9 percent rate of return. The Static-Plan 529 tells you into which mutual funds the money is going. You can't choose the funds, but you see where it is going. You are still locked in, so I don't like these. There are some 529s that are now allowing you to see and choose the mutual funds and even move them if needed. This type is fine AFTER you fund ESAs.
A UTMA, Uniform Transfer to Minors Act, (also known as an UGMA) means you are opening the mutual fund in the child's name. You are merely the custodian of the money. At age 21, this money belongs to the child and is in their control. As you go along, teach them what this means so they are not surprised with $125,000 (could happen!) at age 21. Who knows where they'll spend it!
The UTMA will basically grow tax-free, the reason being that the first $750 (beyond the initial $750) is taxed at the child's rate, and anything beyond that is taxed at the parent's rate. Once the child turns 14, everything beyond the first $750 is taxed at the child's rate.
I recommend the ESA. You have the control. Unless your child is going to Harvard, if you start while they're young, $2,000 a year is going to put them anywhere you want them to go. It won't be enough to put them through medical school, but it grows tax-free, you retain control, and there is a great rate of return. If you make over $200,000 or would like to invest more than $2,000 annually, then the flexible 529 is the next best option.
