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Providence Wealth Advisors, LLC
Douglas DeGroot
20220 S. LaGrange Road
Frankfort, IL 60423
815-306-2020
dougdegroot@providencewealth.com
 
 




Saving for College

The right combination

Ideally, you'll want to choose a college savings vehicle that offers the best combination of tax advantages, financial aid benefits, and flexibility, while meeting your overall investment needs.

Note on 529 plans

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer's official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

Two types of 529 plans

A 529 savings plan lets you save money for college or K-12 tuition in an individual investment-type account. A 529 prepaid tuition plan lets you prepay college tuition at participating colleges at today's prices for use in the future.

College and K-12

A Coverdell education savings account is a tax-advantaged education savings vehicle that lets you save money for college or K-12 at public, private, or religious schools.

A "qualified education expense"

To be tax free at the federal level, the investment funds of certain savings vehicles have to be used for "qualified education expenses." Surprisingly, this can mean different things depending on the savings vehicle.

 

Tax-Advantaged Ways to Save for College

In the college savings game, all strategies aren't created equal. Should you choose a 529 plan, a Coverdell account, a custodial account, or a mutual fund? The best savings vehicles offer special tax advantages if the funds are used to pay for college.

Tax-advantaged strategies are important because over time, you might be able to accumulate more money with a tax-advantaged investment compared to a taxable investment. (However, lower maximum tax rates for capital gains and dividends, as well as the tax treatment of investment losses, could make the investment return for a taxable investment more favorable.) Ideally, you'll want to choose a savings vehicle that offers the best combination of tax advantages, financial aid benefits, and flexibility, while meeting your overall investment needs.

529 plans

Since their creation in 1996, 529 plans have become to college savings what 401(k) plans are to retirement savings — an indispensable tool for saving money for a child's or grandchild's college education.

There are two types of 529 plans — savings plans and prepaid tuition plans. Though each is governed under Section 529 of the Internal Revenue Code (hence the name "529" plans), savings plans and prepaid tuition plans are very different savings vehicles.

529 savings plans

The more popular type of 529 plan is the savings plan. A 529 savings plan is a tax-advantaged savings vehicle that lets you save money for college and K-12 tuition in an individual investment-type account, similar to a 401(k) plan. Some plans let you enroll directly, while others require you to go through a financial professional.

The details of 529 savings plans vary by state, but the basics are the same. You'll need to fill out an application, name a beneficiary, and select one or more of the plan's investment portfolios to which your contributions will be allocated. Also, you'll typically be required to make an initial minimum contribution, which must be made in cash.

529 savings plans offer a unique combination of features that no other education savings vehicle can match:

Federal tax advantages: Contributions to a 529 account accumulate tax deferred and earnings are tax free if the money is used to pay the beneficiary's qualified education expenses. (The earnings portion of any withdrawal not used for qualified education expenses is taxed at the recipient's rate and subject to a 10% penalty.)

State tax advantages: Many states offer income tax incentives for state residents, such as a tax deduction for contributions or a tax exemption for qualified withdrawals. However, be aware that some states limit their tax deduction to contributions made to the in-state 529 plan only.

High contribution limits: Most plans have lifetime contribution limits of $350,000 and up (limits vary by state).

Unlimited participation: Anyone can open a 529 savings plan account, regardless of income level.

Wide use of funds: Money in a 529 savings plan can be used to pay the full cost (tuition, fees, housing, food, books, supplies) at any accredited college or graduate school in the United States or abroad; for certified apprenticeship programs (fees, books, supplies, equipment); for student loan repayment (there is a $10,000 lifetime limit per 529 plan beneficiary and $10,000 per each of the beneficiary's siblings); and for K-12 tuition expenses up to $10,000 per year.

Professional money management: 529 savings plans are offered by states, but they are managed by designated financial companies who are responsible for managing the plan's underlying investment portfolios.

Flexibility: Under federal rules, you are entitled to change the beneficiary of your account to a qualified family member at any time as well as roll over (transfer) the money in your account to a different 529 plan once per calendar year without income tax or penalty implications.

Accelerated gifting: 529 savings plans offer an estate planning advantage in the form of accelerated gifting. This can be a favorable way for grandparents to contribute to their grandchildren's education while paring down their own estate, or a way for parents to contribute a large lump sum. Under special rules unique to 529 plans, a lump-sum gift of up to five times the annual gift tax exclusion amount ($18,000 in 2024) is allowed in a single year, which means that individuals can make a lump-sum gift of up to $90,000 and married couples can gift up to $180,000. No gift tax will be owed, provided the gift is treated as having been made in equal installments over a five-year period and no other gifts are made to that beneficiary during the five years.

Transfer to ABLE account: 529 account owners can roll over (transfer) funds from a 529 account to an ABLE account without federal tax consequences. An ABLE account is a tax-advantaged account that can be used to save for disability-related expenses for individuals who become blind or disabled before age 26.

Variety: Currently, there are over 50 different savings plans to choose from because many states offer more than one plan. You can join any state's savings plan.

But 529 savings plans have a couple of drawbacks:

No guaranteed rate of return: Investment returns aren't guaranteed. You roll the dice with the investment portfolios you've chosen, and your account may gain or lose value depending on how the underlying investments perform. There is no guarantee that your investments will perform well enough to cover college costs as anticipated.

Investment flexibility: 529 savings plans have limited investment flexibility. Not only are you limited to the investment portfolios offered by the particular 529 plan, but once you choose your investments, you can only change the investment options on your existing contributions twice per calendar year. (However, you can generally direct how your future contributions will be invested at any time.)

529 prepaid tuition plans

Prepaid tuition plans are cousins to savings plans — their federal tax treatment is the same, but their operation is very different. A 529 prepaid tuition plan lets you prepay tuition at participating colleges, typically in-state public colleges, at today's prices for use by the beneficiary in the future. Prepaid tuition plans are generally limited to state residents, whereas 529 savings plans are open to residents of any state. Prepaid tuition plans can be run either by states or colleges, though state-run plans are more common.

As with 529 savings plans, you'll need to fill out an application and name a beneficiary. But instead of choosing an investment portfolio, you purchase an amount of tuition credits or units, subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of college tuition in the future, no matter how much college costs may increase between now and then.

However, if your child ends up attending a college that doesn't participate in the plan, prepaid plans differ on how much money you'll get back. Also, some prepaid plans have been forced to reduce benefits after enrollment due to investment returns that have not kept pace with the plan's offered benefits.

Even with these limitations, some college investors appreciate not having to worry about college inflation each year and want to lock in college tuition prices today. The following table summarizes the main differences between 529 savings plans and 529 prepaid tuition plans:

529 savings plans529 prepaid tuition plans
Offered by statesOffered by states and private colleges
You can join any state's plan (though some plans may require you to enroll with a financial professional)State-run plans require you to be a state resident
Contributions are invested in your individual account in the investment portfolios you have selectedContributions are pooled with the contributions of others and invested by the plan
Returns are not guaranteed; your account may gain or lose value depending on how the underlying investments perform.Generally a certain rate of return is guaranteed in the form of a percentage of tuition being covered in the future, no matter how much costs may increase by then
Funds can be used for a wider range of expenses, including the full cost of college or graduate school in the U.S. or abroad, apprenticeship programs, student loan repayment, and K-12 tuition expenses Funds can be used only for tuition at participating colleges (typically state colleges); room and board and graduate school generally are not eligible expenses

Coverdell education savings account

A Coverdell education savings account (Coverdell ESA) is a tax-advantaged education savings vehicle that lets you save money for college, plus elementary and secondary school (K-12) at public, private, or religious schools. Here's how it works:

Application process: You fill out an application at a participating financial institution and name a beneficiary. There may be fees associated with opening and maintaining the account. The beneficiary must be under age 18 when the account is established (unless he or she is a child with special needs).

Contribution rules: You (or someone else) make contributions to the account, subject to the maximum annual limit of $2,000. This means that the total amount contributed for a particular beneficiary in a given year can't exceed $2,000, even if the money comes from different people. Contributions can be made up until April 15 of the year following the tax year for which the contribution is being made.

Investing contributions: You invest contributions as you wish (e.g., stocks, bonds, mutual funds, certificates of deposit) — you have sole control over your investments.

Tax treatment: Contributions to your account grow tax deferred, which means you don't pay income taxes on the account's earnings (if any) each year. Money withdrawn to pay college or K-12 expenses (a qualified withdrawal) is completely tax free at the federal level and at the state level too. If the money isn't used for college or K-12 expenses (a nonqualified withdrawal), the earnings portion of the withdrawal will be taxed at the beneficiary's tax rate and subject to a 10% federal penalty.

Rollovers and termination of account: Funds in a Coverdell ESA can be rolled over without penalty into another Coverdell ESA for a qualifying family member. Also, any funds remaining in a Coverdell ESA must be distributed to the beneficiary when he or she reaches age 30 (unless the beneficiary is a person with special needs).

Not everyone can open a Coverdell ESA — your ability to contribute depends on your income. To make a full contribution, single filers must have a modified adjusted gross income (MAGI) of less than $95,000 and joint filers must have a MAGI of less than $190,000.

Custodial accounts

Before 529 plans and Coverdell ESAs, there were custodial accounts. A custodial account allows your child to hold assets — under the watchful eye of a designated custodian — that he or she ordinarily wouldn't be allowed to hold in his or her own name. The assets can be used to pay for college or anything else that benefits your child (e.g., summer camp, a computer). Here's how it works:

Application process: You fill out an application at a participating financial institution and name a beneficiary. There may be fees associated with opening and maintaining the account.

Custodian: You designate a custodian to manage and invest the account's assets. The custodian can be you, a friend, a relative, or a financial institution. The assets in the account are controlled by the custodian.

Assets: You (or someone else) contribute assets to the account. The type of assets you can contribute depends on whether your state has enacted the more common Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). Examples of assets typically contributed are stocks, bonds, mutual funds, and real property.

Tax treatment: Earnings, interest, and capital gains generated from assets in the account are taxed every year to the child under special "kiddie tax" rules that apply when a child has unearned income. The kiddie tax generally applies to children under age 18 and full-time college students under age 24 whose earned income doesn't exceed one-half of their support. Under the kiddie tax rules, a child's unearned income over a certain threshold ($2,600 in 2024) is taxed using parent income tax rates.

In addition to the kiddie tax rules, there are other drawbacks too: all gifts to a custodial account are irrevocable, and money can only be withdrawn for the child's benefit. Also, when the child reaches the age of majority (either 18 or 21, depending on state law), the account terminates and the child gains full control of all the assets in the account.

U.S. savings bonds

Series EE and Series I bonds are types of savings bonds issued by the federal government that offer a special tax benefit for college savers. The bonds can be easily purchased from most neighborhood banks and savings institutions, or directly from the federal government. They are available in face values ranging from $50 to $10,000. You may purchase the bond in electronic form at face value or in paper form at half its face value.

If the bond is used to pay qualified education expenses and you meet income limits, the bond's earnings are exempt from federal income tax. (The bond's earnings are always exempt from state and local tax.) In 2024, to be able to exclude all of the bond interest from federal income tax, married couples must have a modified adjusted gross income of $145,200 or less at the time the bonds are redeemed (cashed in), and individuals must have an income of $96,800 or less. A partial exemption of interest is allowed for people with incomes slightly above these levels.

The bonds are backed by the full faith and credit of the federal government as to the timely payment of principal and interest, so they are considered a relatively safe investment. They offer a modest yield, and Series I bonds offer an added measure of protection against inflation by paying you both a fixed interest rate for the life of the bond (like a Series EE bond) and a variable interest rate that's adjusted twice a year for inflation. However, there is a limit on the amount of bonds you can buy in one year, as well as a minimum waiting period before you can redeem the bonds, with a penalty for early redemption.

Roth IRAs

Though technically not a college savings account, some parents use Roth IRAs to save and pay for college. In 2024, you can contribute up to $7,000 per year ($8,000 per year if you are age 50 or older). Earnings in a Roth IRA accumulate tax deferred. Contributions to a Roth IRA can be withdrawn at any time and are always tax free. For parents age 59½ and older, a withdrawal of earnings is also tax free if the account has been open for at least five years. For parents younger than 59½, a withdrawal of earnings — typically subject to income tax and a 10% premature distribution penalty — is spared the 10% penalty if the withdrawal is used to pay for a child's college expenses.

Not everyone is eligible to contribute to a Roth IRA, though — it depends on your income. To contribute the full amount in 2024, your MAGI must be $146,000 or less if your filing status is single or head of household and $230,000 or less if you're married and file a joint return.

Qualified education expenses

To be tax free at the federal level, investment funds have to be used for "qualified education expenses." Surprisingly, this can mean different things depending on the savings vehicle.

529 savings plans: Qualified education expenses for 529 savings plans include the full cost of tuition, fees, room and board, books, equipment, and computers for college and graduate school; the cost of certified apprenticeship programs (fees, books, supplies, equipment); principal and interest payments on a qualified student loan (there is a $10,000 lifetime limit per 529 plan beneficiary and $10,000 per each of the beneficiary's siblings); and K-12 tuition expenses up to $10,000 per year for enrollment at an elementary or secondary public, private, or religious school (excluding homeschooling).

Housing and food (formerly room and board) is a qualified expense only if the student is enrolled at least-half time. If the student lives on campus, room and board is limited to the actual amount charged by the school; if the student lives off campus or at home, room and board is limited to the college's specific published room and board allowance figure. Also, special needs services are a qualified expense only if they are incurred by a beneficiary with special needs in order to enroll or attend.

529 prepaid tuition plans: Qualified education expenses for 529 prepaid tuition plans generally include just tuition and fees for college only (not graduate school) at the colleges that participate in the plan.

Coverdell ESAs: Qualified education expenses include college and K-12 expenses and cover tuition, fees, room and board, books, equipment, computers, tutoring, uniforms, and transportation.

U.S. savings bonds: Qualified education expenses include tuition and fees for college, plus contributions to 529 plans and Coverdell ESAs. Room and board, books, equipment, and computers are not qualified education expenses.



IMPORTANT DISCLOSURES Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

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Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2024.