From getting your college savings plans started to later tax implications, we've got information on the most commonly asked college education savings questions.
The cost of college continues to rise at a rate that outstrips inflation. It’s no surprise that many parents are starting early to save up for their kids.
“College savings plans can be one way to set aside money over time to help your kids pay for college,” said Dara Luber, senior manager, retirement product at TD Ameritrade. “The more you understand, however, the more likely you are to choose what’s right for your family.”
If you’re trying to figure out college savings plans, here are some of the most commonly asked questions—and their answers.
There are two main types of college savings plans:
Luber also pointed out that you can use a custodial savings account on your child’s behalf. However, these don’t have the same tax advantages as an account specifically designed for saving for college.
A 529 plan is designed to allow you to invest toward college and comes with tax benefits. Although contributions to 529 plans don’t come with a federal tax benefit, many states offer a tax deduction when you make a contribution. Additionally, any growth is federally tax-free, as long as it’s used for qualified education costs when you withdraw.
Even if you use a state’s plan, your child isn’t bound to go to a school in that state. Funds from a 529 college savings plan can be used at more than 6,000 higher education institutions in the United States — and can even be used at some foreign universities.
A Coverdell Education Savings Account (ESA) is also a tax-advantaged account designed to help families save for college expenses. Contributions aren’t tax-deductible, however, any earnings grow federally tax-free as long as withdrawals are used for qualified expenses.
Limits for contributions are lower for the Coverdell than for the 529 college savings plan, however, even though you might have access to more investment choices in a Coverdell account and might also save on fees.
“The biggest difference between the two is the contribution limit,” said Luber. “With a Coverdell, only $2,000 can be contributed each year, and that’s in total.”
She explained that if parents contribute $2,000 to a beneficiary’s Coverdell in the year, grandparents can’t contribute to the account.
On the other hand, it’s possible to contribute more to a 529 college fund. For 2019, you can contribute $15,000 per individual without incurring the federal gift tax. If you’re married and filing jointly, you can contribute up to $30,000 per beneficiary.
“In fact, contributors can even contribute up to $75,000 a year without incurring the gift tax, because they can count the current year and four annual gifts for future years,” said Luber. “A 529 is the only way to contribute so much money without incurring the gift tax.”
Another difference is that you can’t contribute to a Coverdell for a beneficiary who has reached 18 years of age, whereas with a 529, there is no age limit. Plus, if the original beneficiary doesn’t use the 529 funds, you can name a new beneficiary. The case isn’t so simple with a Coverdell.
Finally, your contributions are capped for a Coverdell when you reach a certain adjusted gross income. There are no income limitations for 529 plans.
When you withdraw money from a 529 plan, you can use it for a number of college expenses, including:
Recently, it became possible to use up to $10,000 from a 529 to pay for tuition at K-12 schools in some states. However, before you withdraw money for this use, Luber recommended speaking with a tax professional.
A Coverdell ESA can be used to pay for tuition, books, and uniforms. However, Coverdell accounts have always been available for K-12 education costs.
No matter what account you use, it’s important to save up for college if you plan to help your child cover those costs. If you can grow the account tax-free and get a potential state tax benefit, it can make a lot of sense to consider a college savings plan.
An investor should consider a 529 plan’s investment objectives, risks, charges and expenses before investing. A plan’s Program Disclosure Statement, which contains this and more information, should be read carefully before investing.
Investors should consider before investing whether their or their beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program and should consult their tax advisor, attorney and/or other advisor regarding their specific legal, investment or tax situation.
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Participation in a 529 plan does not guarantee that contributions and the investment return on contributions, if any, will be adequate to cover future tuition and other higher education expenses, or that a beneficiary will be admitted to or permitted to continue to attend an eligible educational institution.
TD Ameritrade does not provide tax advice. Every individual’s tax situation is different, and it is important to consult a qualified tax advisor regarding the application of a plan’s benefits to your own individual situation.
Investments in 529 plans are not guaranteed or insured by the FDIC, SIPC or any other government agency, and are not deposits or other obligations of any depository institution.
Withdrawals used to pay for qualified higher education expenses are typically free from federal income tax. These expenses include tuition, fees, books, computer equipment and software, supplies and equipment required for enrollment at a qualified institution of higher education. Room and board is considered a qualified education-related expense if the student is enrolled on at least a half-time basis.
The earnings portion (if any) of a Non-Qualified Withdrawal will be treated as ordinary income to the recipient and may also be subject to an additional 10% federal tax penalty.
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