We’ve all heard the stories of young adults drowning in student loan debt. There are certainly benefits for students who have some “skin in the game,” but much of the financial burden will still be on the shoulders of parents, and to an increasingly greater extent, grandparents.
It’s never too early to start saving for the kids’ college expenses, and as the costs of a higher education continue to climb, it’s probably a good idea. The latest figures from the College Board show the average annual cost of attendance for an out-of-state public university is about $35,000, and private schools average about $10,000 more per year. Even in-state public school costs have risen dramatically—College Board says average annual tuition, fees, and room and board costs rose above $20,000 for the 2016–17 school year.
You have options for setting aside and managing those educational funds, and it’s important to know the rules and tax implications.
Your Magic Number: 529
Among the tools for parents and grandparents to help plan for college is a 529 plan. A 529 is an education savings plan operated by a state or educational institution. It can be used at a qualified college in any state, according to Saving for College, an information site for college savings and planning. Although 529 plans vary from state to state, such plans generally offer federal tax-deferred growth and withdrawals that are free from federal income taxes. There are no income or age limits, and many plans do not limit contributions.
Here are a few things you need to know:
- Depending on the plan you choose, 529s can offer flexibility in terms of contributions and investment choice.
- Parents and grandparents can each open their own accounts, or grandparents can contribute to an account in the parents’ names.
- Because distributions from a parent-owned 529 account to pay for the current year's college expenses are generally not considered part of your adjusted gross income, such distributions should not affect the next year's financial aid eligibility.
A word on gift taxes: According to the IRS, in general, gifts are taxable, and it is the donor who pays the tax, but there is an annual exclusion of $14,000 per beneficiary. Saving for College also points out that you could also gift up to $70,000 and spread it over five calendar years, meaning it would count as the current year's $14,000 gift and for four future years' gift money. And since you and your spouse count as two separate donors, even if you are married filing jointly, the two of you could contribute up to $140,000 in a single calendar year, and spread it over five calendar years. You can make these gifts to as many beneficiaries as you want all without gift tax.
Coverdell: It’s a Savings Plan, Not a Brand of Cosmetics
Perhaps a lesser-known savings vehicle is the Coverdell Education Savings Account. Like 529s, Coverdell plans also allow earnings to grow tax-free and will not be taxed at withdrawal when they are used to pay for qualified education related expenses. But unlike 529s, the Coverdell can also be used for education expenses for children in kindergarten through high school—tuition, books, and even school uniforms.
Is there a catch? Well, yeah; sort of.
The maximum annual contribution to a Coverdell account is $2,000—possibly a small percentage of annual education costs, even at the K–12 grade levels. Plus, the allowable contribution amount phases out between $95,000 and $110,000 for single filers and $190,000 to $220,000 for joint filers, according to the IRS. Coverdell accounts, however, can offer a variety of investment options, and some may have lower fees than 529 plans, according to Saving for College.
And of course, if you start early, those $2,000 contributions can really add up.
You can also set up custodial accounts for students under two legislative acts: the Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA). These allow you to transfer ownership of assets to children and have the assets held by a custodian until they become adults. Such accounts are not tax-deferred, but earnings are taxed at the child’s rate, which may be lower or even exempt from federal tax, depending on the child’s total assets.
One thing to note about custodial accounts is that, because the assets belong to the student, they will be counted among the student’s asset base in financial aid determinations.
Planning and saving for college can be overwhelming, sure, but don’t let confusion over account types delay you from checking out the choices that exist, and the potential outcomes of starting early.
Educational Resources All in One Place
The cost of college is high, but an education account can help you invest toward your child’s college expenses down the road.