The inflation we’re experiencing doesn’t bode well for parents who hope to see their children go to college. Historically, the costs of a college education have risen faster than the rate of inflation. But keeping ahead of rising education costs can be less formidable for parents who avail themselves of federal plans to incentivize college savings.
Parents have a few options in choosing a college savings plan, each offering different advantages, tax treatments, flexibility and savings options. Selecting the one most suited for your family’s situation comes down to your financial circumstances, tax status, capacity to save and college preferences.
Here’s a brief overview of the college savings plans available to all families:
529 College Savings Plans
The 529 plan is the most popular vehicle used by parents to accumulate funds for a college education. As a qualified plan, the 529 plan offers the opportunity to accumulate education funds free of current taxes, which means they can accumulate more quickly. If the funds are used to pay for qualified education expenses including tuition, fees, books, and room and board, they can be withdrawn tax-free. Funds can also be used to fund the cost of apprenticeship programs.
As a result of recent tax law changes, 529 plans can be used to cover expenses for k-12 education in addition to secondary education costs. The difference is withdrawals for k-12 expenses are limited to $10,000 per year, while there is no limit for secondary education costs. Under the SECURE ACT enacted in 2019, 529 plan funds can also be used to pay down student loan debt of the plan’s primary beneficiary or their siblings, up to a maximum of $10,000 per student loan.
While there is no limit on how much parents, grandparents or other family members can contribute to a 529 plan, contributions over $15,000 per year are subject to the federal gift tax. However, you can “frontload” the plan with up to five years’ worth of contributions ($75,000). Although you won’t be able to make additional contributions for five years, the lump sum of money will have more time to compound, and grow tax-deferred. You can also change the beneficiary of a 529 plan without penalty.
529 plans are offered by various states, though you aren’t necessarily limited to investing in any one plan. You can shop around for a plan based on fees and performance. You may find better investment options in a plan from another state. However, many states also offer a tax deduction for contributions made by in-state residents.
Pre-paid tuition plans
If you know the state or university system you want your child to attend, you can use a pre-paid tuition plan. Your contributions go toward the accumulation of credits that can be applied directly to a specific college to cover tuition and other education expenses. When you start the plan, a formula is applied to determine the number of credits that need to be accumulated based on the inflation rate and a minimum interest rate. In some cases, the sponsoring state or institution offers to guarantee to cover tuition costs even if they exceed the pre-determined formula.
It’s important to note that the credits can only be applied to colleges within the state or the schools participating in the program. Also, some states are reconsidering the tuition guarantees, so there’s a chance your credits might not be enough to cover the full tuition.
Education Savings Account
Some parents find the limited investment options available in a 529 plan to be a disadvantage. As an alternative, Education Savings Accounts (ESAs), also known as Coverdell Education Savings Accounts, offer the same tax incentives as a 529 plan, but they can be established as a brokerage account with many more investment options. This may be more appealing to parents who want to create a particular asset allocation strategy with more diversification.
Like 529 plans, the funds from an ESA can be withdrawn tax-free to cover qualified education expenses for both k-12 and secondary educations. The downside is ESAs are limited to a $2,000 annual contribution from any family member who wants to contribute. Also, the ability to contribute to an ESA is phased out for higher earners, starting at $100,000 for individuals and $200,000 for married couples.
The most significant advantage of an ESA is that funds accumulated in it do not preclude you from qualifying for education tax credits, such as the Lifetime Learning Credit. In addition, because an ESA is established in the parents’ names, accumulated funds aren’t counted towards financial aid eligibility. That’s a significant advantage over a 529 plan where the assets and withdrawals are considered to be owned by the child.
Starting a college savings plan now can give you a leg up on rising college costs. But it would be essential to seek the guidance of an advisor experienced in college savings planning to fully understand the advantages and disadvantages of the different plans as they apply to your needs and circumstances.