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 plansThe 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 plansPrepaid 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 plans | 529 prepaid
tuition plans |
---|
Offered by states | Offered 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
selected | Contributions 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 accountA 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 accountsBefore 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 bondsSeries 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 IRAsThough 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 expensesTo 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. |