Guide to College Savings Plans
With the average cost of an in-state four-year degree nearing $100,000 and a private education often triple that, many families are wondering how best to prepare for the eventual cost of attending college without burdening children with heavy student loan debt.
Fortunately, there are several tax-advantaged programs available to pay for the cost of college. When starting early, you have years to build up balances in the accounts, reducing out of pocket costs and loans required to complete an education.
529 Savings Plans
Fast becoming one of the most popular options for college savings is the 529. These state-run programs offer a variety of investment options and offer both state and federal tax-free growth using after-tax funds. Each state offers different programs, and they do not require state residency to participate. 529 accounts work a lot like a company 401K. You choose from a list of investment options and can move funds around among those options at will.
Generally speaking, if you purchase a plan from your state of residence, you enjoy both federal and state tax-free withdrawals when using the money for qualified educational purposes. Some states offer additional incentives such as matching grants to encourage participation. Choosing an out of state plan will typically eliminate federal taxation, but not the state. Students can use funds at any accredited college or University both private and public without any age restrictions.
529s feature low minimum deposits and allow multiple people to contribute to the same account, making it easier to build balances faster. The upper limit on contributions can exceed $200,000 but vary by state. There are no income restrictions allowing anyone to participate.
Treatment of Assets
Another key benefit to a 529, is that balances count as a parent’s assets, even though you list the child as a beneficiary. This change reduces the impact on qualifying for need-based financial aid. Using the grandparents as the custodian can remove the funds completely from the FASFA form, but may lead to higher student assets upon distribution.
Each state designs their own program resulting in a variety of fee structures and investment choices across states. Given the longevity of the investment consider both the investment options and the associated account fees before choosing a plan. You may find you will earn more in an out of state plan, even after considering state taxation at the time of withdrawal, due to these two factors.
Withdrawals in a 529 must be used for qualified higher educational expenses to maintain tax-free treatment. Primary educational institutions do not qualify. You may use funds for both adults and children without age restrictions. You can also transfer the account to another qualifying family member. Withdrawing funds for uses other than educational needs will result in paying taxes on gains as well as a penalty at the federal level.
529s rely on market risk to grow funds. The balance will rise and fall based on the performance of the funds you choose.
Prepaid Savings Plans
Prepaid savings plans can be a form of 529 which is run by the state, provided by a group of universities or a single university. Plans focus on paying for tuition, with limited options for the room and board portion of higher education. Not all states offer a pre-paid program.
Most state-run funds require either the custodian or the beneficiary to be a resident of the state. Private plans also add a restriction to attending a university within the approved group.
Most plans require a one-time deposit or accept automatic payments through installments. Much like 529s, there are high maximum contribution limits which allow you to potentially pay your child’s entire tuition bill before completing high school.
Treatment of Assets
The plan holds the account in the child’s name and account balances count as the child’s assets for purposes of qualifying for need-based financial aid.
Students must use funds for qualified higher educational expenses. The credits or units cover the cost of classes in the form of tuition. You must use funds at a qualifying university, based on the plan, to gain the tax-free benefits.
Pre-paid plans center around paying for college at today’s rates. With the cost of a college education outpacing inflation, you are buying college units or credits at today’s prices, locking in the price to avoid inflation. State programs will sometimes guarantee the account eliminating the need to rely on market growth. The biggest benefit of a pre-paid plan is as a hedge against the rising cost of tuition.
Coverdell Savings Plans
Once called an Educational IRA, the Coverdell plan works similar to a Roth IRA. You set up an account with the parent or grandparent as the custodian and the child as the beneficiary.
Low minimum deposits and a wider range of investment choices is a key benefit to a Coverdell Savings Plan. You can choose among any mutual fund, bond, or stock on the market, giving you the most choice of any plan. The downside, is the contribution limit of $2,000 per year, per child. You can reach the $2,000 limit up to Tax Day the following year.
Contributions also face income limits. Single tax filers begin to lose the full contribution amount at $95,000, where couple filing a joint return can deposit the full $2,000 per child up to $190,000, with a phase out beyond that.
Treatment of Assets
The plan is a custodian account in the child’s name, and balances do count as the child’s assets when qualifying for need-based financial aid.
To qualify for tax-preferred treatment, you can use funds for any qualified educational expenses, including costs associated with attending a private primary school. Tuition, room and board, books and required fees all qualify as an educational expense. There is a 10% penalty for using funds for non-educational needs.
You must use all the funds by the beneficiaries 30th birthday or reassign the funds to another beneficiary, such as a sibling. Failure to do so will result in taxation of any remaining balance.
The account will experience market growth based on the investment selections you choose. The longer you leave the account to grow, the more potential for larger balances.
While you do not receive any reduced taxation at the time of the contribution, all three accounts allow you to take advantage of tax-free growth and withdrawals when using funds for high educational needs. The list of qualified institutions goes beyond colleges and universities and includes many community colleges and even trade schools.