In the past parents had limited options as to how they wanted to save to send their scholars to college. Today there are quite a few options available to both the parents as well as the prospective students. While that variety offers parents more flexibility, it adds the task of thorough research on the part of the parents to make sure they pick a plan that is right for them.
The following is a general overview of the college savings options available today. As always, you’ll want to discuss what it is that you are looking for with your financial professional before making a decision. Also, be mindful of the fact that the specific features available in 529 plans vary from state to state.
Coverdell Education Savings Account (ESAs):
These plans, originally introduced in 1997, are known as Education IRAs. It only lets parents set aside $500 per year. The plan now has a new name and higher contribution limits. Parents can now invest up to $2,000 per year in these accounts. The earnings on your investments in these accounts are free from taxation as long as your withdrawals are made to pay for qualified school expenses.
Under new rules, money in the accounts can be used to pay not only for college but also for education expenses that may be incurred for children in grades K-12. ESAs can also be converted to 529 plans without the account owner suffering any type of tax penalty. Generally, when applying for financial aid, students are expected to use 35% of their assets to pay for each year of school, while parents’ assets are assessed at a maximum rate of 5.6%. ESAs are counted as assets of the owner of the account, most often than not these are the parents, and so, when applying for financial aid, therefore can have less of an impact on the amount of financial aid received than money in a custodial account would.
529 Prepaid Tuition Plan and College Savings Plans:
These plans are offered generally by the state’s 529 plans, named for the section of the Internal Revenue Code that governs them, come in two varieties — college savings plans and prepaid qualified tuition plans. Both plans allow annual taxes to be deferred and earnings withdrawn from the account are also free of taxation if they’re used to pay for qualified school expenses.
The prepaid tuition plans offer protection against future tuition increases. They let parents buy tuition credit at rates that are offered today, and these credits can be used years down the road when your children are ready for college. Please note that this may vary from state to state, and so it is important to ensure that you do your research.
College savings plans don’t offer any guarantees on investment returns, however, like an IRA or 401(k), they allow the account owners to choose their investment strategy from the offered options. These plans offer custodians the opportunity to earn returns above the yearly tuition inflation rate.
Forty-nine states and the District of Columbia offer 529 college savings plans. Many plans are national and thereby available to residents of any of these 49 states. About half of the states’ plans offer an additional state income tax benefit, for the student who chose to go to school in-state. Still, even parents who live in states with residential tax benefits may want to compare all of their options before making a choice. A college saving plan from another state may offer advantages, the tax benefits of participating in the in-state plan might not.
Like an ESA, money in 529 plans is considered the account owner’s asset. If a student is not the account owner, it could be expected that a 529 plan won’t reduce financial aid as much as money in a custodial account can.
When putting money into 529 plans, however, parents need to be mindful of the fact that they may have an additional plan fee that other investments, such as custodial accounts, do not have. Also, investments in 529s involve investment risks. You should consider your financial needs, goals, and risk tolerance prior to investing. 529 plans also offer unique gifting and estate tax benefits.
Under current rules, one of the two parents can gift up to $14,000 annually, ($28,000 per married couple) per beneficiary without being subjected to federal gift-tax consequences. The unique feature of 529 plans allows you to gift up to $70,000 ($140,000 per married couple) as long as your contribution is at least $14,000 and you spread it over a five-year period to each prospective student. You will not incur federal gift taxes as long as no additional gifts are made to the beneficiary for four years after the year during which you make the one-time gift.