Expenses, tuition hikes and the rising cost of an education are commonly heard phrases when planning for education expenses. Planning and saving can be daunting, since education related expenses are rising faster than inflation and other non-education related expenses. The 10-year historical inflation rate for education related costs is approximately 5%1, while the 10-year average rate of inflation for non-education related expenses is much lower. To avoid a feeling of helplessness when it comes to such a critical stage of your child’s life, pre-planning is key. What is the best way to save for your child?
- Early – start now, your money needs time to grow. As your investments appreciate, they will compound, which means your appreciation will appreciate too.
- Set aside a consist amount of money that you want to save for your child on an annual or monthly basis. For example, if you decide on $6,000 per year, you can do this all at once, or save $500 per month. The key is to choose a method that works for you and that you can stick with.
- Tax-free. 529 plans and Coverdell ESA accounts are wonderful ways to save for your children and allow you to take the money out free of taxes, as long as it’s used for qualified education costs.
Over the past few years, 529 plans have become the premier method of saving for college. The plans allow for tax-free growth, significant contribution limits and do not impose income limitations. Additionally, with the recent change in tax legislation, 529 funds are now eligible to be used federally tax free for up to $10,000 a year per child in qualified tuition expenses for K-12 education.
These plans are now the gold standard for college savings. They allow a much larger contribution amount than a Coverdell ESA (discussed below). The aggregate plan limit depends upon the state plan you choose but ranges from $235,000-$520,000. There are no age restrictions and some states offer additional tax incentives. Like Coverdell ESAs, if the funds are used for qualified education expenses, they will come out of the account tax-free. Unlike Coverdell ESAs, 529 plans do not have modified adjusted gross income limitations in order to participate. In addition, the fees/expenses and investment choices are reasonable in most cases.
There are 2 types of 529 plans – prepaid tuition plans and college savings plans. Prepaid tuition plans lock in the tuition at the state plan’s state school, allowing you to pay for future years of college at today’s costs. Since the inflation rate of education expenses is so high, this is essentially matching your investment rate of return with the rate of inflation for education expenses. Not all states offer prepaid tuition plans and most have residency requirements. The drawback to this type of plan is that your child is limited to colleges included in that specific plan, however, the funds can usually be transferred or refunded in case your child chooses a different school but fees may apply.
College savings plans, on the other hand, do not lock in the tuition but give the beneficiary the option to use the funds at any institution. In a 529 college savings plan, contributions are allocated to specific investments selected by the account owner. The accounts value then depends upon the growth of the investments held in the account. Typically, these plans only allow the plan beneficiary to change investment allocation twice a year. However, age-based allocations have become popular. They become increasingly more conservative as the child reaches college age. This type of allocation avoids the need to make ongoing investment modifications.
529 Plan Quick Facts
- Contributions of up to $15,000 per year may be made to a 529 college savings plan by an individual without triggering the need to file a gift tax return. This amount matches the annual gift tax exclusion for 2018, which is indexed periodically for inflation.
- Contributors may choose to make accelerated gifts lumping 5 years of gifts into one year (under IRC Section 529(c)(2)(B)), allowing a contribution of up to $75,000 per individual to a 529 plan beneficiary in a single year, prohibiting additional gifts to the account over the next 5 years.
- Contributions may be withdrawn tax-free when used for qualified higher education expenses, including tuition, room and board, fees, books, supplies, and equipment, including computers. Contributions up to $10,000 per child per year may also be withdrawn federally tax-free when used for K-12 tuition payments. Certain states may still charge tax on distributions used for K-12 tuition expenses.
State Tax Benefits:
- Some states offer resident participants of their plan an incentive to choose their plan by giving a state tax deduction for a portion of the contribution amount (up to a set limit). Please note that this only applies to in-state participants, and California does not offer such incentive tax benefit.
- There is no maximum age for contributions, and there is no maximum age for funds to remain inside the plan as well. Funds that do not end up being needed for a beneficiary can be used for another beneficiary who is a family member of the original beneficiary. For example, if the beneficiary does not go to college, the funds in the account can still be used by another family member. If the funds are not ultimately used for eligible educational expenses, then any growth in the account is taxed as ordinary income and is subject to a 10% penalty.
- For purposes of the FAFSA, funds in a 529 plan are treated as an asset of the parents, regardless of whether they are owned by the parent or the child. If the child is not a dependent, however, then the account will be treated as an asset of the child. If the 529 plan is owned by a grandparent, it is not included in the financial aid evaluation, however, distributions from the plan count as income of the beneficiary for purposes of the Free Application for Federal Student Aid (FAFSA).
Another option to 529 plans are Coverdell accounts, but their implementation is much more limited.
A Coverdell ESA (previously known as an Education IRA) allows you to contribute up to $2,000 per year per beneficiary as long as your modified adjusted gross income does not exceed $95-110K for single filers or $190-220K for married filing joint filers. The $2,000 limit is phased out and then capped for people within these income brackets.
The advantage to Coverdell ESAs is that the funds can also be used for grades K-12. The funds will be tax-free if used for qualified education purposes. The disadvantage is that the funds have to be made for a child under the age of 18 and used by the age of 30. In addition, you can make this contribution until April 15th for the following calendar year.
The first thing to keep in mind when saving for your child’s college education is to take some pressure off yourself and do the best that you can – paying for some of their college bill would be better than none of it. With tuition costs rising faster than inflation and faster than our paychecks, it is imperative to know the facts and plan early. The 529 and Coverdell plans addressed above provide excellent options. You can get your money to work for you (and your children) and take advantage of the tax benefits that are available.
1The College Board® https://www.collegeboard.org/
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