When you’re contemplating funding your children’s college education as they grow, you have many options to choose from. But, in actuality, only one gives you the flexibility you deserve and the protection from tax implications that you need.
According to Chris Considine, Executive Vice President and Director of Wealth Planning at California Bank & Trust, there are a few common saving options, however the 529 plan is the most popular and for good reason.
What is a 529 College Savings Plan?
Designed specifically for education expenses, the 529 College Savings Plan was established as a new part of the tax code in 1996. This type of plan can be used for college expenses or for K-12 private school tuition, but it’s most advantageous when used for college. A couple can contribute up to $30,000 each year per child into this fund (a single parent can contribute up to $15,000) that can be diversified any way you choose within the plan’s investment portfolios among stocks, mutual funds or ETFs, bonds and cash without having to file a gift tax form with the IRS.
Caveats and considerations
The money can grow and you never have to pay taxes on that growth in a 529 plan as long as the funds are withdrawn exclusively to pay for qualified education expenses. If the child for whom the funds are intended chooses not to go to college or vocational school, the earmarked funds can be directed to a younger child or anyone you designate who can benefit from help paying for post-secondary educational expenses or private school tuition. If the funds are used for any purpose other than educational expenses, you’ll be liable for a penalty and applicable taxes.
Although the funds in a 529 plan are limited to paying for educational expenses, this college fund option offers the most flexibility and benefits, Considine says.
“If you put $25,000, for example, into a taxable traditional brokerage account that assumes 6 percent annual growth, you would have about $53,000 available in 18 years, after paying taxes on stock or bond sales, withdrawals and dividends based on being in a 28 percent tax bracket,” he explains. “But if you invest $25,000 in a 529 plan and if that money grows at the same annual rate of 6 percent, you would have about $71,000 available to you in 18 years because you’re not having to pay taxes on accessing those resources. That’s roughly 25 percent more than you would have available in a traditional brokerage account at the end of 18 years.”
Consider the options
You can also opt for “target date” funds within a 529 plan, where at certain pre-designated times based on how many years away college is for the child, stocks in the plan convert, tax-free, into bonds or money market funds, to minimize risk as the child nears college age.
“We recommend clients save about 70 to 80 percent of what they think they’ll need for each child’s post-secondary educational expenses in a 529,” Considine says, in case a child chooses a less expensive venue such as a community college or decides not to pursue post-secondary education.
Another option for a 529 plan is pre-paying tuition, but that opportunity is far more limited than it was when 529 plans were first introduced. Only nine states still allow prepayment for a state university (California isn’t one of them), where the tuition you’ll pay is locked in for your child at a state university at today’s rate.
Super funding a 529
If you want to maximize your contributions to your child’s or grandchild’s 529 plan—especially if the child is already 12 or 13 and doesn’t yet have a generously funded 529 account—you can invest up to five years’ worth of allowable contributions without gift tax consequences into each child’s 529 account, as long as you don’t gift the child any additional money within the next five years.
The advantage: In addition to setting aside as much money as possible for college, you don’t use any of your lifetime gift tax exemption (the 2021 exemption amount is $11.7 million). That means you and your spouse can contribute up to $150,000 at one time into each child’s or grandchild’s 529 plan without gift tax consequences.
“Given that you have such a relatively short window to save for college,” Considine points out, “you really need all the benefits and tailwinds you can possibly come up with, because you want to be able to compound those returns in that 16- to 17-year window to get the biggest benefit from your investment. That’s why a 529 plan is such a great option for so many families.”
Other options for saving
If a 529 plan doesn’t match your goals, Considine shared other plans available for saving:
Coverdell – A Coverdell Education Savings Account is a custodial account offering tax-free earnings growth and withdrawals as long as the funds are spent on what are known as qualified education expenses. This type of account limits annual contributions to $2,000 per child per calendar year.
Roth IRA account – You’re probably familiar with this as a retirement savings vehicle, but you may not know it can be used to help pay for college, too. Contributions and earnings in a Roth IRA grow tax-free because you don’t receive tax deductions up front for your contributions.
The catch is that to be able to withdraw any of the resources within the Roth account tax-free, you must have made your first contribution at least five years prior to withdrawal and you must be at least 59-and-a-half years old at the time of withdrawal. Any money in the account not spent on educational expenses can become part of your retirement portfolio. People currently under 50 can contribute up to $6,000 per year to the account; those over 50 can contribute up to $7,000 each year to the account.
Traditional brokerage account – Because cash and securities in this type of account can be used for any purpose and at any age, you can invest as much as you want for each child every year and watch the investments grow over the first 18 years of your child’s life. The drawback is that you’re liable for taxes on dividends you receive and when it comes time to withdraw money for college, any stocks or bonds that you sell likely will incur capital gains tax from the growth of each since you purchased it.
While your child’s college education seems like a distant future, it’s never too early to start saving for this goal. Talk to your banker or your financial planner to see what options are available for you and your family.