The numbers don’t lie: Higher education is expensive, and the cost keeps rising. FinAid.org predicts that the price of college will increase around eight percent each year, which means that the cost of tuition doubles every nine years.
In the face of such daunting financial figures, it’s no surprise that families and students are going into debt to finance higher education. Our financial planning experts recently outlined several factors to consider before taking out student loans. There is one surefire way to minimize the amount of loans needed to fund higher education: save ahead of time for this considerable expense.
Not only does saving now help ease the cost of college down the road, it also allows savers to reap federal, and in some cases even state, tax benefits in the meantime. Of course, all savings vehicles are not created equal, so it’s important to find the one that best aligns with your unique financial situation. Below, we highlight several of the more popular college savings tools and examine how they help families achieve their savings goals.
529 College Savings Plans
With a name derived from the governing section of the IRS code, it is no surprise that 529 plans offer savers a wide range of tax benefits when funds are used for qualified higher education expenses. Typically sponsored by a state government or individual school, 529 plans come in two varieties: the college savings plan or prepaid tuition plans. In a 529 college savings plan, money is set aside for college in an individual investment account similar to a 401(k) plan for retirement. 529 prepaid tuition plans operate very differently, allowing savers to lock in today’s price for tuition credits for future use.
Both varieties of 529 plans offer significant tax benefits and easy-to-use features, such as:
- State and federal tax-free growth and distributions when used for qualified higher education expenses, such as tuition, room and board, books, etc.
- State tax deduction for contributions (availability may vary by jurisdiction).
- High annual and lifetime contribution limits.
- Flexibility to change beneficiaries or roll over account to another 529 plan.
- Account owner retains control of funds indefinitely; funds are never transferred directly to beneficiary.
- Gift and estate tax benefits up to $70,000 ($140,000 for married couples).
- Wide use of funds at most colleges and trade schools.
- Account is treated as parent/account owner’s asset with less impact on financial aid calculations.
Coverdell Education Savings Account (ESA)
The primary difference between a Coverdell account, formerly known as the Education IRA, and a 529 plan is that funds saved in a Coverdell account may be used for K-12 education expenses, in addition to post-secondary education. Coverdell ESAs are offered by financial institutions, not schools or state governments. Significant features of a Coverdell ESA include:
- State and federal tax-free growth and distributions when used for qualified college or K-12 expenses.
- Annual combined contribution limit of $2,000 a year per beneficiary.
- Rollovers permitted into another qualified Coverdell ESA.
- Unused funds must be distributed to the beneficiary by age 30 (except for beneficiary with special needs).
- Eligibility to open account limited to individuals with adjusted gross income of $110,000 or less ($220,000 for married filing jointly).
- Account is treated as parent/account owner’s asset with less impact on financial aid calculations.
Custodial account (UGMA/UTMA)
Custodial accounts are the original vehicle to set aside money for children under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA). Unlike the more recent 529 plans or Coverdell ESAs, custodial accounts offer less tax benefits and less control over how the assets are used. Here is how custodial accounts work:
- Contributions are not tax-deductible, earnings are subject to federal income or capital gains tax and account balance may trigger “kiddie tax” rules.
- There may be fees associated with opening and funding an account.
- No contribution limits, but federal gift tax will be incurred at current levels.
- Assets may be used for any expense that benefits the child, education-related or not.
- Once the beneficiary turns 18, he or she takes full control of the account assets.
- Beneficiaries cannot be changed and accounts may not be rolled over.
- Account is treated as the child’s asset and weighs heavily in financial aid calculations.
College Savings Vehicle Comparison
SavingForCollege.com offers a helpful tool that allows savers to compare and contrast different savings vehicles according to criteria important to them.
Every dollar saved today is one less that students may have to borrow down the road, so saving for college can be an important component of a family’s financial game plan. In order to maximize the tax benefits, however, it is important that students and families consider the implications of certain savings vehicles or accounts. Your RKL tax professional or RKL Wealth Management financial advisor can help you plot a tax-advantaged course to achieve your college savings goals.
