Sample Article: Saving for college – 529 Plans and Coverdell Education Savings Accounts
It’s no secret that college is expensive. According to the National Center for Education Statistics, the average cost of tuition and fees for a four-year in-state public university was $10,388 per year in the 2020-2021 school year. For a private university, that number jumps to $38,185 per year.
While financial aid is available, it rarely covers the total cost of a college education, leaving many families struggling to find alternative methods to pay for their child’s college education.
If you’re concerned about how to pay for college, a few vehicles for saving are available. In this article, we’ll discuss two ways you can help your child save for college, even if they qualify for some form of financial aid.
One of the best ways to save for college is through a 529 plan. A 529 plan is a tax-advantaged, state-administered savings plan that can be used to pay for qualified education expenses, such as tuition and fees, room and board, and books and supplies. You can also use the funds to pay up to $10,000 of student loan repayments. And as a result of the SECURE Act, 529 plans can now be used to pay for kindergarten through 12th-grade tuition as well.
How it Works
There are two types of 529 plans: prepaid tuition plans and education savings plans. Prepaid tuition plans allow you to purchase credits at a participating school that can be used to cover the future cost of tuition and fees. This enables you to lock in the current tuition price instead of worrying about ever-increasing costs down the road and can be great for students who already know where they will be going to school.
529 education savings plans, on the other hand, work similarly to a 401(k) or IRA. With an education savings plan, you contribute money to the 529 account, which is then invested. The earnings are tax-free so long as they are used for qualified education expenses. Contributions to a 529 account are made post-tax and thus are not tax-deductible. However, over 30 states offer state income tax deductions or credits for 529 plan contributions. You usually must contribute to an in-state 529 to be eligible for the state income tax benefit.
529 plans offer flexibility by allowing owners to change beneficiaries from one family member to another. So, if you have more than one child, they can all potentially benefit from the same 529 plan as long as there are enough funds in the account. Likewise, if one child decides not to attend college, you can switch the account beneficiary to another member of the beneficiary’s family to pay for their education.
While most 529 plans do not have annual contribution limits, they are considered gifts and thus will count against your annual gift tax exemption ($16,000, or $32,000 for married filers in 2022) and lifetime gift tax exemption if more than the annual limits. For those who would like to make one large contribution, 529 plans offer the option to treat a single lump-sum payment up to $80,000 in one year as if it were made over five years to shelter a larger amount from taxes; however, there can be no additional contributions for the same beneficiary over the next five years.
529 plans have aggregate contribution limits set by each state on the total amount that can be contributed. These limits range from $235,000 on the low end to $550,000 on the upper end.
Penalties and Taxes
If you withdraw any 529 funds before the beneficiary incurs qualified expenses or use the funds for non-qualified expenses, you will be subject to taxes and penalties. Any earnings from the invested contributions will be taxable in addition to a 10% penalty. Fortunately, the contribution amounts are not subject to these taxes and penalties since they were made post-tax.
Coverdell Education Savings Accounts
Another way to save for college is through a Coverdell Education Savings Account or an ESA. A Coverdell ESA is a tax-advantaged trust or custodial savings account that can be used to pay for qualified education expenses like tuition, boarding, and supplies. Like 529 plans, an ESA can also be used to pay for qualified elementary and secondary education expenses in addition to college expenses. However, the beneficiary cannot use them for student loan repayments.
How it Works
ESAs work much like a Roth IRA. They both allow you to make an annual non-deductible contribution to a special investment account. The ESA investment account can grow tax-free as long as withdrawals are used for qualified education expenses. And unlike 529 plans which limit how contributions can be invested, Coverdell accounts enable holders to choose any form of investment they believe will have the most growth potential.
It’s worth noting that Coverdell ESAs are subject to specific requirements that do not apply to 529 plans. First, when the account is established, the beneficiary must be under 18 unless they are a beneficiary with special needs. Tax laws also prohibit contributions to an ESA once the beneficiary reaches 18 unless the beneficiary is a special needs beneficiary.
Second, contributions to the ESA must eventually be distributed to the beneficiary, even if they are not used for qualified education expenses. Unlike 529 plans, you cannot simply refund the account back to yourself. Instead, you must distribute the funds to the beneficiary, who will be subject to taxes and penalties if the funds were not used for qualified education expenses.
Coverdell ESAs also have lower contribution limits than 529 plans. For 2022, the maximum contribution limit is $2,000 per year. There are also restrictions on the income level of the contributors to an ESA for any tax year contributions are made. Married contributors must have a modified adjusted gross income of less than $190,000 to qualify for the maximum annual contribution of $2,000. The maximum contribution is then gradually phased out if adjusted gross income falls between $190,000 and $220,000. The adjusted gross income limit for single taxpayers is reduced to $95,000 and phased out by $110,000. No income limits apply if the contributor is a trust or organization.
Suppose a withdrawal exceeds the beneficiary’s qualified education expenses or is used for non-qualified expenses. In that case, the earnings will be taxable to the beneficiary, and the IRS will also levy a 10% penalty on the gains. And if the contributor exceeds their maximum annual contribution limit, the beneficiary will be subject to a 6% excise tax on the excess amount.
Coverdell funds must be used by the time the beneficiary reaches age 30 unless they are a special needs beneficiary. If the funds are not used by this time, they must be distributed within 30 days after the designated beneficiary reaches age 30, and they will be subject to taxes and penalties.
However, a Coverdell ESA can be transferred to another member of the beneficiary’s family to be used for their qualified education expenses. Families with more than one student could potentially avoid the forced distribution, taxes, and penalties when the first beneficiary reaches age 30.
While 529 plans are almost always preferable to an ESA - because of state tax incentives and higher contribution limits - Coverdell ESAs may offer more investment flexibility and greater potential for growth for savvy investors. ESAs can also effectively complement 529 savings plans without the risk of reducing the contributor’s lifetime gift and estate tax exemption.
In a word, 529 plans and Coverdell ESAs are not mutually exclusive. Not only can they be used together, but a Coverdell can also be rolled over into a 529 plan without incurring taxes so long as the funds are deposited in a 529 account for the same beneficiary in the same tax year.
This article is intended to provide a brief overview of ways to save for college and is not a substitute for speaking with one of our expert advisors. If you’d like to learn more about saving for college and which method is optimal for you, please contact our office.
Call us at (314) 433-5800 or fill out the form below and we'll contact you to discuss your specific situation.
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