When bringing a newborn home from the hospital, your child’s college expenses may seem like a lifetime away. Feedings, diaper changes, and finding time to catch some sleep are most certainly a priority. While you may not feel like you have an abundance of time at the moment, time is on your side when it comes to saving for your child’s college expenses. Starting a savings plan early increases your chances of success later.
There are several methods for saving for your child’s future education. The most common are 529 plans and education savings accounts (ESA), also known as Coverdell accounts. Depending on your unique situation, one method may be preferable to another.
A 529 plan is a platform designed to encourage saving for future education costs. They are sponsored by states and state agencies authorized by Section 529 of the Internal Revenue Code. There are two types of 529 plans: prepaid tuition plans and education savings plans.
Prepaid Tuition Plans
Prepaid tuition plans allow you to purchase credits at participating colleges and universities (usually public and in-state) for future tuition and fees at current prices for the beneficiary (child). They typically cannot pay for future room and board and do not allow you to prepay tuition at elementary and secondary schools.
529 Education Savings Plan
A 529 education savings plan is probably the more well-known type of 529 plan. It allows you to set up an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary. The account may be invested into a preselected set of portfolios or mutual funds.
Contributions are not deductible from federal income taxes, but your investment grows on a tax-deferred basis and can be withdrawn tax-free if the money is used to pay for qualified education expenses. Qualified expenses include tuition, fees, books, supplies, computer equipment, and room and board. Certain costs associated with K-12 tuition, participation in a registered apprenticeship program, or payment of a qualified education loan up to $10,000 may also be considered qualified education expenses. The earnings portion of a nonqualified withdrawal is subject to federal and state income tax and a 10 percent penalty.
Education Savings Accounts
An ESA is set up and managed by a parent or other adult for the benefit of a minor. The contributions into an ESA have the same tax treatment as a 529 plan. However, unlike a 529 plan, there is an aggregate maximum contribution limit of $2,000 per student per year until the child’s 18th birthday (subject to income phase-out). Contributions must be made by the standard tax-filing deadline of April 15 following the end of the tax year, with no extensions.
Investment options are more flexible for an ESA than a 529 plan. They include stocks, bonds, CDs, mutual funds, exchange-traded funds, and others. Like a 529 plan, earnings in an ESA grow tax-deferred, and you can make tax-free withdrawals when the money is used for qualified education expenses.
Qualified expenses include tuition, fees, books, supplies, computer equipment, and room and board for elementary, secondary, or post-secondary education at an eligible educational institution. Other qualified expenses are academic tutoring, uniforms, transportation, and supplementary services, such as extended day programs as required or provided by the school. Qualified distributions may be made for college students attending an “eligible educational institution” at least half-time. The earnings portion of a nonqualified withdrawal is subject to federal and state income tax and a 10 percent penalty.
When the designated student reaches age 30, all remaining assets in an ESA must be distributed to the student. If the student does not use the funds for education by age 30, the funds may be passed on to another direct family member under the age of 30 (i.e., siblings, nieces, nephews) for payment of their education expenses.
College can be one of the most significant steps in your child’s future, but it is getting more expensive. The good news is that you can ease the financial burden by planning ahead. The 529 plan and ESA are two vehicles specifically designed to help you do just that. Talk to your tax or financial professional to see if either of these vehicles or another strategy may be a good fit for you.