Saving For College
With 2022 ending soon and the holiday gifting season in full swing, you may be considering a contribution to a child or grandchild’s education. With the rising cost of tuition, adding to a child’s education savings could be a welcome gift! In fact, one survey showed that only about 36% of parents are informed on college savings plans, and an even smaller number knows of the various ways to save for something so valuable.
There are three main types of accounts to save for college — Coverdell Educational Savings Accounts (ESAs), 529 plans, and Roth IRAs. Here’s what you need to know about each:
Coverdell ESAs (commonly known as Coverdells, educational savings accounts, or ESAs) were introduced under the Taxpayer Relief Act of 1997 and named after the late U.S. Senator Paul Coverdell. A Coverdell account will have two primary parties — a trust/custodian/owner who will establish the account and control the funds, and a beneficiary who will receive the funds. Coverdells are used by families in lower income brackets who do not plan to contribute more than $2,000 per year, will make all contributions before the beneficiary turns 18, and are certain the student will have completed their education before the age of 30. Coverdells also have an income restriction limit of $110,000 for single parents and $220,000 for couples. The investment options are very flexible with the owner of the account having discretion.
Another advantage of Coverdell accounts is that all elementary, secondary, and college tuition and expenses, such as a personal computer, can be covered. While the contributions are not tax deductible, they do grow tax-free, and none of the appreciation, interest, or capital gains are taxed upon withdrawal as long as the funds are used for the beneficiary’s education in a given year. Only the excess withdrawn is taxed as normal income. Furthermore, once the beneficiary turns 30, all remaining funds are also taxed as normal income.
A 529 plan is most commonly known as a state-sponsored “qualified tuition program” that offers a number of tax benefits. There are two main types of 529 plans: prepaid plans and savings plans. The prepaid plans allow an individual to purchase tuition credits at today’s rate and use them later. They are administered by states or specific educational institutions. Nine states offer prepaid tuition plans – Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas and Washington.
The second type of 529 plan is the traditional savings plan. The contributions grow based upon market performance of the underlying investments, which are often mutual funds selected by the investor. Most 529 plans offer age-based allocations with a more aggressive investment strategy when the child is younger, and a more conservative strategy as the beneficiary gets closer to attending college. Contribution limits for 529 plans are also significantly higher, often allowing up to the gift tax exemption amount. In addition, there are no income restriction levels or limitations on the age of the beneficiary. One potential disadvantage is that the investment options may be limited to a series of mutual funds offered by the plan administrator. These plans fully cover college tuition and expenses as well as elementary and secondary tuition. You may also be eligible for a tax deduction on the contribution.
A Roth IRA allows an individual to make after-tax contributions and later withdraw those funds tax-free when retired. But what do Roth IRAs have to do with saving for college? A Roth IRA allows you to withdraw money you’ve contributed tax- and penalty-free prior to retirement, provided the funds qualify for educational expenses. These funds must be contributed by the account owner; however, parents and grandparents often give the student funds, up to their earned income, allowing the student to fund a Roth IRA. The income restriction limit for single parents at $143,999 and $213,999 for couples. The annual contribution limit is $6,000 or $7,000 if the account owner is older than 50. Unlike 529 accounts and similar to Coverdells, the investment options are very flexible. Another advantage of Roth IRAs is they are not considered college savings assets on the Free Application for Federal Student Aid (FAFSA) form and will have no impact on the student’s financial aid eligibility.
All Coverdells, 529 plans, and Roth IRAs have advantages, but since each situation is different, no one-size-fits-all solution exists. To determine what makes the most sense for you and your family, please reach out to your Savant advisor.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant.
Certified Financial Planner Board of Standards Inc. (CFP Board) owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the U.S., which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.