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 increasingly, grandparents are chipping in for college.
When you’re researching how to pay for college, the first step is to realize it’s never too early to start an education fund. As the costs of a higher education continue to climb, it’s probably a good idea.
So how much does it cost to go to college? The latest figures from the College Board show that the average cost of college varies. The average annual cost to attend an out-of-state public university is nearly $36,500, and private schools average about $47,000. Even in-state public school costs have risen dramatically—average annual tuition, fees, and room and board costs nearly $21,000 for the 2017–18 school year, according to College Board.
You have choices for setting aside, investing and and managing those educational funds, and it’s important to know the rules and tax implications when researching how to afford college.
Your Magic Number: 529
A 529 plan is one way to invest toward college. 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 have high lifetime contribution limits.
Also, some states may offer in-state tax benefits to residents using the state 529 plan.
Here are a few things you need to know:
- Flexibility. Depending on the plan you choose, 529s can offer flexibility in terms of contributions and investment choice.
- Account structure. Parents and grandparents can each open their own accounts, or grandparents can contribute to an account in the child's name.
- Tax and financial aid eligibility advantages. 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 $15,000 per beneficiary, which increases slightly this year (starting January 1, 2018). Amy Heller, senior specialist, retirement and 529 products at TD Ameritrade, points out that you could also gift up to $75,000 and spread it over five calendar years, meaning it would count as the current year's $15,000 gift and 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 $150,000 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.
The new federal tax code changes allow parents who send their children to K–12 private school to use 529 funds for expenses, but before you begin withdrawals, Heller cautions parents to further research their choices with education. She says the 529 industry as a whole is still working through many of the changes, because states need to catch up to the new federal rules.
“The story here is, yes, the federal bill changed to allow for K–12 expenses, but the account owner needs to check with a qualified tax advisor and their state to make sure the state statutes allow for those withdrawals to be qualified,” she says.
And before you buy a laptop for your fifth grader, it looks like the only qualified expense for K–12 students is tuition, and up to $10,000 a year per beneficiary, she says.
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.
How popular these plans will be remains to be seen, now that 529 plans can be used for K-12 tuition. Heller says it’s a little early to comment on whether account owners are changing how they use education funds. However, she says, one thing parents will need to consider when deciding how to use their 529 plans is some basic math.
The idea behind saving early for college is that parents have a longer time horizon to invest and potentially compound returns. Using a 529 to pay for K-12 tuition essentially draws down the balance sooner.
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, investing, 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 benefits 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.