College $?$?$ — When, How, and How Much?
Understanding Education Investment Accounts
Keeping your investments on track to match the cost of a college education can feel insurmountable. Historically, higher education costs have outpaced inflation, and that’s not going to change any time soon. Over the past nine years, general inflation has averaged 1.84%, while education costs have increased an average of 5.71%. This trend does not show signs of slowing down, despite constant discussion of higher education cost reform.
Parents of toddlers and high school kids alike ask, slightly panicked, “How much is it going to cost … and how are we going to pay for it?” I count myself among you. My four kids are still pretty young, but I know in a blink I’ll be sending them to college, one right after the next.
For everyone, the first, most basic, step to feeling confident about funding a college education, or a few, is to have a plan – an affordable, flexible, tax-favorable plan. Most plans knit together several or many different pieces to create a college funding strategy, based on income level and what type of school your kids will likely attend. Whatever the pattern your plan follows, there are three main categories of education accounts that can help you amass investment earnings to pay for education costs: 529 Plan Accounts, Coverdell Education Savings Accounts, and custodial accounts.
Probably the most well known of education savings options, 529 plans were created by Congress in 1996. These plans are formally known as “Qualified Tuition Programs,” and called “529s” because the state legislation that governs them is found in Section 529 of the Internal Revenue Code. These accounts use either a prepaid tuition or savings plan model, purchased independently or through a broker. Some states offer both types. You do not have to invest in the plan operated by your own state. But many states offer tax incentives for residents, and some even match a percentage of what you invest in your account.
The most familiar type of 529 account follows a savings plan model. These 529s are investment accounts that operate as either “static portfolios,” remaining the same over time unless changed by the owner, or “age-based,” which means that as your student gets closer to college age, the mix of investments within the plan’s portfolio becomes more conservative, lower risk. States offering 529 savings plans impose a maximum annual contribution limit of $14,000 per account. At the federal level, all contributions are after-tax, but account earnings are not taxed, and distributions of those earnings are tax-exempt when withdrawn for qualified education expenses, which include tuition, room and board, books, tutoring, and computer equipment. In order to remain tax-exempt, the money in a 529 account must be used at an eligible, accredited college or university, graduate school, community college, or vocational-technical school within the US. You, the account owner, retain control of the funds in a 529 account, and can make a withdrawal at any point.
If your student, your 529 account beneficiary, receives a scholarship, the dollar amount of that scholarship may be withdrawn from the account without a tax penalty. You many also change the named account beneficiary without penalty. Say, for instance, your oldest child is accepted to the Naval Academy. Your college costs for that kid just went way down – the Naval Academy pays the full cost of that four-year education in exchange for service. What do you do with all that money you managed to save in his 529 account? You change the named beneficiary to kid number two, your daughter hoping to go to Harvard.
Different from a 529 plan savings account, the prepaid tuition type of 529 account offers savings only for tuition expenses. When you invest in this type of plan, your return is determined by the guaranteed value of tuition benefits, not investment performance. The plan locks in the cost of tuition when you open the account, and you are investing in the plan’s commitment to pay your student’s tuition for a specific number of semesters at one of your state’s public institutions. You can pay into the account in a lump sum, or you can pay for a chosen number of tuition credits and add more over time, keeping in mind that credits purchased later will cost more as tuition prices for your state’s plan continue to rise. Your contributions to a prepaid plan are after tax, but withdrawals for tuition payment are not taxed. Currently, only a small number of states offer prepaid 529 plans, and most of them restrict enrollment to families meeting state residence requirements. If you open a prepaid tuition account, and then your student decides to attend a private or out-of-state school, the payment made by your plan is based on average tuition costs at the public institutions in the state where your plan originates.
Coverdell Education Savings Account (ESA)
This kind of account used to be known as an Education IRA. Contributions into a Coverdell ESA are limited to $2,000 per year until the beneficiary reaches age 18. Similar to a 529 account, contributions are not tax deductible, but the earnings are tax deferred, and the distributions are tax-exempt when used for qualified education expenses.
The main difference between a 529 account and a Coverdell ESA is that you choose the vehicles to invest in, depending on the amount you’re investing, your risk tolerance, and how close your student is to needing the money in the account. Another significant difference between the 529 accounts and Coverdell accounts is that money from Coverdell ESAs may be used for elementary and secondary education expenses, not only for higher education expenses. All funds in a Coverdell ESA must be distributed by the time the beneficiary reaches age 30.
Custodial Accounts are the most flexible type for investing on behalf of a minor beneficiary. They can actually be used for expenses other than education expenses, for the benefit of the minor named on the account. Funds within a custodial account are considered “irrevocable gifts,” and become the property of the beneficiary once deposited. Custodial accounts allow unlimited annual deposits, and also let you direct the selection of your investments the way a Coverdell ESA does. Money can be withdrawn from a custodial account tax-free at any time as long as that money is used for the designee’s benefit, whether for education, housing, medical care, or other necessary expenses. However, when the account beneficiary reaches the age of majority (this is often 21, but determined on a state-by-state basis), any money in a custodial account becomes his or hers, without qualification, to spend, save, or reinvest in another way. Varying tax rates apply to withdrawals of income from these accounts – the initial $1,000 may be withdrawn tax-free. The next $1,000 is taxed using the beneficiary’s tax bracket, and the any additional earnings withdrawn are taxed at the original account owner’s tax rate. Please see a qualified tax advisor before you manage the funds.
This material is for informational purposes only and should not be construed as investment advice. The information contained in this article is believed to be accurate, however, it should not be relied upon to make any personal investment decisions. Every person has a different situation and should consult their own tax and financial advisor to determine the best course of action.
U.S. Department of Labor, Bureau of Labor Statistics, Washington, D.C., 2015
irs.gov. Internal Revenue Service, 11-Aug-2016. Web. October 2016
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savingforcollege.com. Saving for College, LLC, 2016. Web. October 2016