Saving for College and Post-Secondary Education: 529 Plans, Coverdell ESAs, and Custodian Accounts

The rapidly increasing cost of higher education and the amount of student loan debt graduates are taking on to pay for it are both astounding. And if you’re a parent who wants to help your child get a good start in life, they can be very concerning. In the broadest sense, we all know what we need to do to prepare: start saving.

But what is the best way to save for your child’s education? And how should that savings be invested?

There are many ways you can save and invest for college and post-secondary education. You don’t need a special type of plan, you just need to save and invest while paying attention to your time horizon. However, by saving and investing through a 529 Plan or a Coverdell ESA you can also benefit from tax savings. That’s more of your money that can be reinvested toward education costs.

529 Plans

There are two types of 529 Plans: college savings plans and prepaid tuition plans. 529 Plans are offered by individual states.

529 College Savings Plan: A 529 College Savings Plan is an investment account opened for a designated beneficiary to pay for post-secondary education. The investment options available depend on the specific plan, but you can typically expect a variety of mutual funds to choose from. You are not limited to the 529 plans offered in the state where you live. You can choose a plan from another state. And the school the beneficiary attends can be in yet another state. It’s important to research the investment options, fees, and other factors such as required minimum contributions.

The appealing feature of the 529 College Savings Plan is the favorable tax treatment. Under IRS rules the account’s earnings and withdrawals are tax-free if used for qualified education expenses. Some states also provide tax benefits. Qualified expenses include tuition, fees, books, room and board (including off campus rent), supplies, computers, and equipment required by the school. The expenses must be paid to a qualified college, university, or post-secondary education institution.

Since 2018, you can also use 529 plan funds to pay up to $10,000 per year for K-12 tuition as well. The funds from this plan can also be used for graduate school.

If the plan funds are not used for qualifying expense, the earnings portion of the funds become subject to ordinary income taxes and a 10% penalty. For example, let’s say over the years you contributed $10,000 to the 529 plan, and the balance grew to $17,000. If the funds were not used for qualifying education expenses you would have to pay ordinary income tax and a 10% penalty on $7,000.

There are no income qualifications to make contributions to a 529 plan. Anyone can. And the IRS does not limit the amount of money that can be contributed. However, some individual plans may set contribution limits.

What happens if your kid doesn’t go to college?

You have the ability to change the designated beneficiary to a qualifying family member. You can even change the beneficiary to yourself.

Prepaid Tuition Plan: Prepaid Tuition Plans allow you to make tuition payments now, at today’s rate, for a designated beneficiary to attend an eligible public or private college in the future. This helps protect against the rising cost of tuition. By making payments to the plan, either by a lump sum or periodic payments, you are getting a guaranteed tuition rate. Your contributions are not applied to an investment account. Instead, you are paying for a specific number of semesters, or units that can be redeemed for a certain percentage of the school’s tuition. Only specific schools are covered by this plan. Not every state offers this type of plan and there may be residency requirements.

What if the beneficiary decides to go to a school that is not covered by the plan?

You can still use the money you contributed toward their higher education. The money is portable. However, you will not get the guaranteed tuition rate.

What if the beneficiary does not go to college?

Like the college savings plan you can change the beneficiary. Switch to a younger sibling if necessary. There may be restrictions preventing you from switching it to an older sibling. You can also get what you contributed back. However, there may be cancelation fees.

Coverdell Education Savings Accounts: Coverdell Education Savings Accounts, commonly referred to as Education Savings Accounts (ESAs) have the same tax advantages as 529 Plans. The account is established with a designated beneficiary. Earnings are tax-deferred and withdrawals are tax-free if used for qualifying education expenses. Private elementary school and high school tuition can be paid with these accounts as well.

ESAs can be established at brokerages, mutual fund companies, and other financial institutions – rather than by states. The designated beneficiary must be 18 years old or younger when the account is established. (There are exceptions for beneficiaries with special needs.) And there’s a time limit on when the money can be used tax-free. Any money left in the account when the beneficiary turns 30, must be distributed within 30 days to avoid penalties.

The maximum amount that can be contributed to the account is $2,000 per year. Contributions are not tax-deductible. More than one ESA can be established for a beneficiary. However, the aggregate amount for all accounts cannot exceed the $2,000 yearly limit. So it’s important that family members know what each other are doing so as not to exceed this limit.

There are income limits that affect who is eligible to make contributions. Currently, if you are single and your modified adjusted gross income is $95,000 or less you can make the whole $2,000 contribution (for married filing jointly, $190,000 or less.) Once your income exceeds these amounts, your eligibility to make the full $2,000 contribution phases out. You’re no longer eligible to make a contribution at all if you’re single and your modified adjusted gross income is more than $110,000 — $220,000 for married couples filing jointly.

When you open an ESA, there are more investment options than with a 529 plan. You can invest in almost anything – with some limitations. For example, you can’t invest in life insurance. But you can choose which financial institution you want to open an account with. This is one of the advantages that ESAs have over 529 College Savings Plans, where you are limited to what the plan offers.

If distributions exceed the cost of the qualified education expenses, the gains are taxed at the account holder’s rate. There is also a 10% penalty if they are not used for qualifying education expenses. There are exceptions to the penalty. For example, if the beneficiary receives a scholarship, dies, or becomes disabled. If the designated beneficiary does not go to college, you can change the account beneficiary to another family member.

Custodian Accounts

Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) are accounts established by parents, grandparents, or any adult, for the benefit of a minor. These accounts can be established at any financial institution such as a brokerage, mutual fund company, or bank. The investment options are unlimited. The adult that establishes the account is the custodian and directs all investment decisions. The funds do not have to be used strictly for education costs. They just have to be used for the benefit of the beneficiary.

There are tax advantages to these accounts. The first $1,050 in investment earnings is not subject to federal income tax. The next $1,050 is taxed at the child’s federal tax rate. Earnings that exceed $2,100 are taxed at the rate that applies to trusts and estates.

When the child reaches the age of majority, 18-25 depending on the state, the money is theirs. They will have complete control over the account. This can be a concern depending on the individual beneficiary. Once the minor has legal control of the money, they can do whatever they want with it.

Choosing the right school

Helping your child choose the right school and career path is just as important as having a solid savings and investment plan. Getting sound career and college counseling is a must! College and any post-secondary education is a big investment in both time and money. It’s important to make sure the job opportunities exist and the compensation is worth the time and effort of the degree.

Keeping the cost of school down is also important. Is it necessary to go to an expensive private school? Or can the local state college be just as good for the field the student wants to enter? What about completing the first two years at a community college? And what about trade schools? All of this should be explored with a career counselor.

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