What’s the best way to pay for college? It’s a question every parent asks, and rightfully so, with the average cost of tuition—not including room and board, supplies and other expenses—over $33,000 at a private nonprofit four-year institution last year according to The College Board.1 Rates grew by 2.4 percent beyond increases in the Consumer Price Index each year at private colleges and 3.5 percent at public institutions from 2006-07 to 2016-172–and will likely continue on that path.
529 plans and Coverdell Educational Savings Accounts (ESAs) are often underutilized investment options that can help parents plan for the high cost of college.
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Named after the section of the tax code that created them, 529 plans are similar to 401(k)s or IRAs in that they enable you to select from mutual funds or other lower-risk plan options. You can grow the investments tax-free over time to pay, in this case, for higher education expenses.
Coverdell Educational Savings Account can also offer tax-free earnings growth potential and tax-free withdrawals. But these can be used even sooner for qualified K-12 education expenses for beneficiaries under the age of 18 or with special needs, and there are some other differences between these two plans.
As time continues to go by in the blink of an eye, here are four things you need to know about these plans, starting first with 529s.
Two Words: Tax Break
One of, if not the biggest, advantage of 529s is the potential for tax-deferred growth of your investments. Earnings grow on a tax-advantaged basis, and the money is tax-free when it is withdrawn and used for qualified education expenses at most accredited colleges and universities. Earnings can be spent on tuition, fees and other related expenses for an eligible student.
Many states, and Washington D.C. also offer a tax deduction on the contributions made to in-state 529 plans. A Morningstar study found that 529 investors who got these breaks reduced their state tax bill by $87 for every $1,000 they saved, the equivalent of an 8.7% return in the first year.3
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Flexibility In Investing & Spending
Investors can hold more than one 529 plan at a time, including those from different states. Contribution limits are often high (totaling $300,000 or $400,000 for the plan in some cases), and they can be front loaded. Finally, there are no income restrictions on participation, as with other savings accounts.
In addition to flexibility in investing, 529s also offer a level of versatility in how their earnings can be leveraged. 529s are not a ‘use it or lose it’ plan and do not expire. Plan beneficiaries can be changed if your child doesn’t use all of the money, and they can even be passed down from generation to generation. Savings can be used for tuition for undergraduate or graduate school, technical or trade schools and even some schools abroad. In addition to tuition, savings can be spent on things like computers, supplies, books, room and board. If your child does gets a scholarship, an amount equal to that can be withdrawn without penalty, but you will likely owe taxes on it.
Not All 529s Are Created Equal
While you can choose to invest in a 529 in any state, you may only be eligible for a tax deduction on your contributions, if available, in the plan offered in your state. In addition to this consideration, you should also look at the fees, performance, ratings and investment options of your state’s and other state’s plans. While it may be best to go with your local plan, some have high fees and poor investment options that can drag down returns, reducing the allure to stay local.
Pay for Education Even Before College And/or Into It
If you are looking to add a plan in addition to your 529 or want to gain tax benefits on education expenses even before college, consider the Coverdell ESA.
Married couples that earn less than $220,000 a year can save up to $2,000 each per child in these investment vehicles that are similar to a savings account and can be used to pay for K-12 education. Contributions are not deductible, but savings can grow tax free, and withdrawals can be gained tax free, when used for qualified elementary and secondary education expenses, such as tuition, fees, special needs services, room and board, academic tutoring.
While $2000 per parent per child per year may not sound like much, every little bit helps, and Coverdell ESAs sometimes offer more investment options and lower fees than other plans. If you and your spouse earn more than $220,000 a year, making you ineligible to participate, you may be able to gift the money to your child to make the contribution into their own Coverdell ESA.
After he or she turns 18, the money can be subject to excise tax, and after age 30 the balance must be withdrawn or penalties can apply.
It is also important to note that up to 5.64 percent of the value of a 529 or Coverdell ESA that is owned by a parent or student will be included in the student’s Expected Family Contribution, which can impact financial aid. If a grandparent or other relative owns the account, nothing will need to be reported initially until funds are taken out; a financial advisor can guide you through the details of this process.
If you have questions about saving for college, or would like a second opinion about your investment approach, please contact us. Our mission, at Telemus, is to help you to leverage your wealth to achieve a more enriched life.
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1 https://trends.collegeboard.org/college-pricing/figures-tables/average-estimated-undergraduate-budgets-2016-17
2 https://trends.collegeboard.org/college-pricing/figures-tables/average-rates-growth-published-charges-decad
3 http://time.com/money/collection-post/2802166/best-529-college-savings-plan/
