The new bout of inflation does not bode well for parents who hope to see their children attend college. That’s because college education costs have historically risen faster than the inflation rate. However, the challenge of keeping ahead of rising education costs can be less formidable for parents who use plans created by Congress to incentivize college savings.
Parents have a couple of options when choosing a college savings plan, each offering different advantages, tax treatments, flexibility, and savings options. Selecting the one most suited for your family’s situation depends on your financial circumstances, tax status, savings capacity, and college preferences.
Here’s a brief overview of the college savings plans available to all families:
529 College Savings Plans
The 529 College Savings Plan is the most popular vehicle parents use to save for a college education. The 529 Plan offers the opportunity to accumulate education funds free of current taxes, which means they can grow more quickly. If the funds are used to pay for qualified education expenses, such as tuition, fees, books, room, and board, they can be withdrawn tax-free. Funds can also be used for apprenticeship programs.
As a result of recent tax law changes, 529 Plans can be used to cover expenses for K–12 education in addition to secondary education costs. The difference is that withdrawals for K–12 expenses are limited to $10,000 per year, while there is no limit for secondary education costs.
Under the SECURE ACT enacted in 2019, 529 Plan funds can also be used to pay down student loan debt of the plan’s primary beneficiary or their siblings up to a maximum of $10,000 per student loan.
Many states offer 529 Plans. And since you are not limited to investing in any state’s plan, you can shop around for a plan based on fees and investment performance. You may find better investment options in a plan from another state. However, many states also offer a tax deduction for contributions made by in-state residents.
Contribution Limits
Each state establishes a lifetime contribution limit. For example, in California, total contributions are limited to $529,000, while in Georgia, the limit is $235,000. Generally, parents (or anyone who wants to contribute to the plan) cannot contribute more than $500,000, including any plan earnings. So, for example, if total contributions are $450,000 and the plan earns another $50,000, no more contributions may be made to the plan.
While there is no limit on how much parents, grandparents, or other family members can contribute to a 529 Plan annually, contributions over $18,000 per year ($36,000 per married couple) are subject to the federal gift tax. However, you can “frontload” the plan with up to five years’ worth of contributions ($90,000) and ($180,000 per married couple). Although you won’t be able to make additional contributions for five years, the lump sum of money will have more time to compound and grow tax-deferred. You can also change the beneficiary of a 529 Plan without penalty.
Tax Incentives
Although contributions to a 529 Plan are made with after-tax dollars, earnings inside the account grow tax-free. Withdrawals are tax-free if the funds are used for qualified education expenses. Funds from the plan not used for qualified expenses will be taxed as ordinary income with a 10% penalty.
Unused 529 Plan Funds May Be Rolled Into a Roth IRA
Unused funds from a 529 Savings Plan can be rolled over to a Roth IRA. Until recently, the distribution of funds from a 529 Plan not needed to cover college expenses would be taxed and penalized.
Starting in 2024, beneficiaries of a 529 Plan will be allowed to roll over up to $35,000 in unused funds over their lifetime to a Roth IRA. Rollovers to a Roth IRA are subject to the annual contribution limits. A 529 account must have been established for over 15 years to be eligible. Any contributions in the past five years to the plan and their earnings are not eligible to roll over.
Investment Options
Like 401(k) plans, 529 College Savings Plans are set up as investment accounts. These accounts offer a range of investment options, including equity, bond, global, and money market funds. Fees and investment performance vary from state to state, so evaluating and comparing plans is essential.
Investment Strategy
Once you find the 529 Plan that best suits your needs, choose your investment options. This involves allocating a certain percentage of your monthly contribution to each option depending on your risk profile. Some plans offer an asset allocation tool to help you determine which mix of investments best fits your profile.
You should monitor your plan annually to ensure your asset allocation doesn’t stray from your target allocation and risk profile. For example, as the time horizon grows shorter, you may want to consider shifting your allocation to a more conservative profile to avoid a market decline within a few years of starting college.
Automatic Savings
Most 529 College Savings Plans offer automatic savings, allowing you to make systematic contributions straight from your checking or savings account. For many people, automatic savings is critical to achieving their college savings goals because it ensures that you always have money going into the plan.
Also, with money flowing into your education savings account monthly, your investment will benefit from dollar cost averaging (DCA). As your share prices fluctuate, your monthly contribution will buy more shares at a lower price, lowering your cost basis and increasing your returns as the share prices rise over time.
Pros and Cons of 529 College Savings Plans
Pros:
- Tax advantages: The biggest perk of 529 Plans is the tax benefit. Contributions grow tax-deferred, and withdrawals for qualified education expenses are exempt from federal and often state income taxes.
- High contribution limits: Unlike other retirement accounts, 529 Plans have high contribution limits, allowing you to save significantly over time. While there are no annual contribution limits there is a gift tax limit to consider.
- Favorable financial aid treatment: Unlike other savings accounts, 529 Plans generally have a minimal impact on financial aid eligibility.
- Flexibility: You can change the beneficiary of the account (with some limitations), which provides flexibility if your child’s educational plans change. In some cases, funds can even be used for K-12 tuition.
- Potential for gift tax benefits: By contributing to a 529, you can reduce your taxable estate.
- Rollover unused funds to a Roth IRA: Up to $35,000 can be rolled over to the beneficiary’s Roth IRA.
Cons:
- Restrictions on withdrawals: Funds must be used for qualified educational expenses to avoid tax penalties. Non-qualified withdrawals are taxed as income and may incur an additional 10% penalty.
- State tax benefits: You may only get a state tax deduction or credit if you contribute to your state’s 529 Plan, though some states allow rollovers from other plans.
- Investment options: Investment choices in 529 Plans may be limited compared to a traditional investment account.
- Fees: Fees, including management fees and expense ratios, can be higher than similar investments made outside a 529 Plan.
A 529 Plan is a Good Choice for Families Who:
- Earn at least $190,000 a year ($110,000 for individuals)
- Want to contribute more than $2,000 per year
- Have a child who may still be in school when they are 30
- Are satisfied with the investment choices offered by 529 Plans
- Live in a state that offers tax benefits for 529 Plan contributions
Coverdell Education Savings Account
Education Savings Accounts (ESAs), also known as Coverdell Education Savings Accounts, are an alternative college savings plan with advantages and disadvantages over the 529 Plan. Funds from an ESA can be used for any qualified educational expenses at college, primary, and secondary schools.
Contribution Limit
The downside of ESAs is the $2,000 total annual contribution limit for all contributing family members. Also, the ability to contribute to an ESA is phased out for higher earners, starting at $110,000 for individuals and $220,000 for joint filers.
Tax Incentives
Contributions to an ESA are made with after-tax dollars, meaning they are tax-exempt when your child receives them. However, the withdrawals must meet specific requirements, such as using them by the time your child turns 30. Non-exempt withdrawals can be subject to taxes and a 10% penalty. As long as the funds are used for qualified expenses, they will be tax-exempt upon receipt.
Maintain Financial Aid Eligibility
A significant advantage of an ESA is that accumulated funds do not preclude you from qualifying for education tax credits, such as the Lifetime Learning Credit. Additionally, because an ESA is established in the parents’ names, accumulated funds aren’t counted toward financial aid eligibility. That’s a significant advantage over a 529 Plan, where the assets and withdrawals are considered owned by the child.
Investment Choices
Unlike 529 Plans, ESA accounts can be set up with most financial institutions as brokerage accounts, and almost any investment, including mutual funds, CDs, stocks, and bonds, can be used inside the account.
Family Involvement
When an ESA is established, any family member can contribute as long as the total contribution for any year does not exceed $2,000. If the total contributions exceed $2,000, an excise tax may be applied to the excess unless they are removed promptly.
Pros:
- Broader qualified expenses: Coverdell ESAs allow tax-free withdrawals for a wider range of qualified education expenses than 529 Plans., including K-12 tuition (up to a limit) and higher education costs.
- Investment flexibility: You have more control over the investments within a Coverdell ESA than the limited investment options in many 529 Plans.
- Beneficiary changes: You can change the account beneficiary more easily than with a 529 Plan, as long as the new beneficiary is a relative of the original beneficiary.
Cons:
- Low contribution limit: The annual contribution limit for Coverdell ESAs is significantly lower than that for 529 Plans, capped at $2,000 per beneficiary. This can make it challenging to save a substantial amount for college.
- Income limits: There are income limits for contributions to Coverdell ESAs. If your income exceeds a certain threshold, you may not be eligible to contribute the full amount.
- No state tax benefits: Unlike some 529 Plans, Coverdell ESAs do not offer state-specific tax advantages.
Coverdell ESAs can be a good option if you want to save for K-12 education expenses or have more control over investments. However, the low contribution limit makes them less ideal for solely saving for college than 529 Plans. You can contribute to both a 529 College Savings Plan and an ESA simultaneously, benefiting from the combined higher contribution limit.
A Coverdell ESA would be an ideal option for families who:
- Earn less than $190,000 a year ($110,000 for individuals)
- Feel confident that their child will graduate from college before 30
- Cannot or do not want to contribute more than $2,000 per year
- Want greater flexibility in choosing and managing their investments
- Want to cover expenses for elementary and secondary school
If you choose a Coverdell ESA and wish to change to a 529 Plan, you can roll your plan over if you maintain the same beneficiary. You cannot roll over an ESA to a 529 Plan, but you can maintain the two plans separately.
Bottom Line
Starting a college savings plan can give you a leg up on rising college costs. However, it is essential to seek the guidance of a financial advisor experienced in college savings planning to understand the advantages and disadvantages of the different plans fully. ARQ Wealth advisors are experienced in helping families choose the right college savings options. Please contact us today for a free consultation.
