By Andrew Hatherley on May 10, 2023
Are you anxious about rising higher education costs? College can be a valuable experience, but it’s becoming less affordable since costs are growing at approximately 6% each year, which is more than twice the inflation rate.
However, with the proper foresight and knowledge, you can utilize different investment vehicles to increase the likelihood that your loved ones will have minimal or no student debt. Some accounts, such as 529 plans, have multiple tax advantages that make it easier to accumulate sizable accounts.
529 plans are one of the most common education investment accounts and are administered on a state-by-state basis. Benefits include:
Funds that are invested in 529 plans grow tax-deferred like a 401(k) plan. The distributions aren’t taxable, provided that they’re used for qualified educational expenses. This is a broad term, but it includes tuition, books, supplies, student housing, and more. If you don’t use the funds for qualified educational expenses, then you’ll have to pay ordinary taxes and a 10% penalty.
Every state has different rules for 529 plans. For example, some states like Arkansas let you deduct up to $5,000 per year if you file single or $10,000 if you’re married filing jointly. Others like California, tax 529 plan distributions.
No set contribution limits
Unlike Roth IRAs, IRAs, and 401(k)s, there aren’t set contribution limits. States have their own limits, which can be as high as $529,000 per year! If you contribute more than the annual gift exclusion of $15,000 per beneficiary than this could trigger gift taxes. Consult your tax advisor if you have any concerns.
Minimal impact on FAFSA
The Free Application for Federal Student Aid (FAFSA) is used to determine your eligibility for financial aid. Luckily, 529s owned by the dependent student or parent are considered to be parental assets, which minimally impacts your award.
The first $20,000 of a 529 plan will fall under the Asset Protection Allowance. The remainder will reduce your beneficiary’s aid by 5.64%. So, you’ll lose just $564 per $10,000 above this threshold, which is negligible compared to the tax-deferred investment gains.
Coverdell ESAs are similar to other education investment accounts like 529 plans as they both offer tax-free investment growth for educational expenses. However, Coverdell ESAs differ from 529 plans because they have a low annual contribution limit of $2,000.
Funds in this investment account must be used before the beneficiary turns 30 or taxes and penalties will apply. The only exception to this rule is if your child qualifies as a special needs beneficiary. Despite these stricter rules, this account has the following advantages:
Can be used for all educational expenses
Coverdells can be used for a wider variety of expenses compared to a 529 plan. For example, you can pay for your child’s private high school tuition with this account. It can also pay for academic tutoring and special needs services.
Flexible investment choices
Many education investment accounts only let you invest in mutual or index funds. With a Coverdell ESA, you can invest in securities offered by the plan provider. These can include individual stocks, bonds, ETFs, and mutual funds.
Can have no impact on financial aid
If a child is the owner and beneficiary of the account, then funds won’t impact financial aid awards. The same applies if it’s owned by the beneficiary’s grandparents, a distant family member, or an unrelated party.
UGMA and UTMAs are essentially trusts that hold assets during your beneficiary’s childhood. These can hold various investments like stocks, bonds, mutual funds, ETFs, and even real estate. The biggest difference between the two is that UGMAs hold just paper assets like stocks or mutual funds, while UTMAs can own real estate.
UGMAs are adopted by all the states, while UTMAs can’t be accessed in others like Vermont and South Carolina. Unlike 529 plans or Coverdell ESAs; they don’t offer substantial tax-advantages. The first $1,050 of earnings grows tax-free, the next $1,050 of earnings is taxed at the child’s low or minimal tax rate, while earnings above $2,100 are taxed at the parent’s tax rate.
Yet, the biggest advantages of these accounts are being able to set up trusts without a lawyer and ensuring the beneficiary can’t access funds prematurely. This can reduce the risk of your child spending recklessly or being taken advantage of by unscrupulous third parties.
You might be surprised to see Roth IRAs on this list of education investment accounts. Roth IRAs are very versatile accounts since they offer tax-free growth. This is provided that you’ve had the account for at least 5 years.
Roth IRAs can be powerful tools for educational planning because you can access your basis or contributions. Unlike 401(k)s or IRAs, your basis won’t be under lock and key for decades.
Once you turn 59.5, then you can withdraw Roth IRA funds without taxes or the 10% penalty! This can make it a powerful retirement and education planning tool, especially if you’re an older parent or grandparent.
Unlike Coverdell ESAs, 529 Plans, or other accounts; there are no restrictions for Roth IRA distributions on specific educational expenses. If you’re younger than 59.5, you can distribute $10,000 penalty-free once in your lifetime to pay for higher education expenses.
Yet, a Roth IRA has a low annual contribution limit of $6,000 if you’re younger than 50. You can contribute an additional $1,000 per year once you’re older than 50. Roth IRA account balances don’t impact financial aid, but withdrawals are considered income. This can drastically reduce potential financial aid packages.
It can be unnerving to see annual high tuition rates for private high schools and universities. Public schools are increasing their tuition steadily each year too. Luckily, the right education investment accounts may help give you peace of mind knowing that you’ll be more able to pay for most, if not all of your loved ones’ education expenses.
Knowing the basics of each account like 529 plans, Coverdells ESAs, UGMA/UTMAs, and Roth IRAs may help you more easily plan for expensive higher education costs.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2023 Advisor Websites.