Saving for your child’s education can be a daunting task. You need to calculate how much money must be saved to reach your goal, what type of plan you should contribute to, and what the different tax implications will be. With college costs increasing an average of 5% each year, the price of a college education in the future seems staggering. A child born today will pay more than $237,000 (see chart below) for the average public institution or $536,000 for the average private university by the time they begin college. Determine your average cost from the table below to come up with a projected goal. Keep in mind that additional needs such as a car or plane tickets for trips home, will increase the savings required. Once a target goal has been defined, you may choose among multiple investment options. A common mistake parents make at this point is to place assets (i.e.: stocks, bonds or savings accounts) in the child’s name. Assets in non tax-deferred accounts in the child’s name, will not only cause the child taxation but may cause the child to be phased out of possible financial aid or the HOPE scholarship. Two tax-deferred plans available for education savings are the Coverdell Educational IRA (ESA) and the 529 Plan. Under the Tax Relief Reconciliation Act of 2001, both of these plans have increased tax benefits that allow the claiming of the HOPE or Lifetime Learning Credit. Choosing the right plan is dependent on many factors. Answer the following questions to help determine which plan is right for you:
Projected Costs of a College Education
|College Years||Average Four-Year Cost of Public College||Average Four-Year Cost of Private College|
- Do I want the money to pay for primary education expenses (K-12) or just for college education?
- How much money do I want to contribute?
- Do I want to retain complete control of the funds?
- Do I have a disabled or special needs beneficiary?
- What is my current year Adjusted Gross Income?
A parent or grandparent who wants to control how the money is distributed may choose a 529 plan; however, if they wanted the funds to pay for K-12 expenses, a Coverdell ESA will be required. Understanding how both the ESA and 529 plan works will help you in your final decision. Below are the details on the two plans.
The Coverdell Educational IRA
Much like a Traditional IRA, the ESA is a self-directed tax-deferred account. Contributions into an account are currently limited to $2000 per child. The annual combined contributions from all sources cannot exceed the per child dollar limit. Contributions are allowed to be made by the child or any other individual; and, by corporations or other entities. The income phase out for contributors is an Adjusted Gross Income of $110,000 for single tax filers and $220,000 for joint married tax filers. Contributions may not continue after the child attains age 18 unless they are for account of special needs beneficiaries. A Parent or Guardian must be designated as the authorized person with full authority over how the account is managed, but when the child attains legal age, the child can designate themself custodian with full authority.
Withdrawals from the account can be used for more than just college education expenses. Tax-free withdrawals can also be taken for grades K-12 and can be used to purchase items like computer equipment, internet access or other educational related services. Distributions not used for qualified expenses are subject to income taxes and a 10% tax penalty. If the child is not going to need the money the account can be transferred to another family member without tax penalty. If not used or transferred by the beneficiary’s 30th birthday, all money in the account becomes taxable and distributed to the beneficiary.
The 529 Plan
A 529 plan is a qualified, state-sponsored tax-deferred program. You would open the account in your name with the beneficiary being your child, grandchild or other relative.
Advantages include enhanced gift and estate tax benefits. With the 529 you are allowed to make greater contributions than the Educational IRA. An individual is allowed to contribute up to $75,000 per beneficiary upon the opening of an account without triggering the gift tax (this represents a gift of $15,000 per year for the next five years; additional gifts must not be made until the 5 yr. Period has ended). This enables the account holders to significantly reduce the taxable value of their estate, while helping to pay education costs for the beneficiary. While you can open an account in any state sponsored plan, each state will have different rules on state tax deductibility for state residents. Starting in 2020 Georgia’s 529 program allows for a $4000 state tax deduction (at a 6% state tax rate, that is only a savings of $240).
Unlike the Educational IRA where you can choose any kind of investment, the 529 plan has limited investment choices. The state will typically select a mutual fund company to sponsor their program. Most will offer a ready made selection of mutual funds, with an “age based” portfolio option or some form of “static” options. With the “age based” option the company selects the investments from equities, fixed income and cash, based on the child’s age. They would take a more aggressive position in the early years and a more conservative approach as the child gets closer to college age. “The static” option would allow the owner to choose among the available funds, providing them the ability to create a more aggressive or more balanced portfolio.
Under the 2017 Tax Reform Law, you can now withdrawl up to $10,000 per year for pre-college expenses without penalty. This rule has not been adopted by all states, so check with your advisor before pulling money out. (Georgia residents are ok)
The account holder retains greater control with a 529 plan as the parents control the assets even after the child reaches age 18. The account holder controls the withdrawals and can even change the beneficiary at any time. Starting in 2002 tax-free distributions are allowed from these plans for qualified post-secondary education expenses including actual living expenses. Most 529 plans have very low contribution requirements, giving you the option of putting as little as $15.
A child can be the beneficiary of both an Educational IRA and a 529 plan. Whichever you chose, the key to funding is to start early. Assuming a 7% annual return, a savings goal of $237,000 for a new born child to attend public college in 18 years, could be attained with a monthly contribution of about $550.*
*Does not represent actual results, results are not guaranteed and may vary with market conditions.