The kids are back in school! For many parents and grandparents, this can be a great time to think about the future education needs of those you hold most dear.
As you consider the cost of college, there are many tax-focused savings strategies that can help. We outline three of the most popular ones here.
Since contribution limits vary from year to year and rules/regulations can vary from state to state we recommend contacting us or your tax preparer to discuss the right strategy for your particular situation.
529 College Savings Plans
529 plans are flexible, tax-advantaged accounts designed specifically for education savings. While your money is in the account, no taxes will be due on investment earnings. When you take money out for qualified education expenses, withdrawals are federal income tax-free (state tax rules vary).
Flexibility is key. The money in a 529 can be used for a wide range of college expenses at accredited schools in addition to certain tuition expenses for K-12, apprenticeship costs, and student loan repayments. Additionally, if your child doesn’t want to go to college, you can change the beneficiary to another child in your family. You can even roll over distributions from one 529 plan into another 529 plan established for the same beneficiary (or another family member) without tax consequences. Parents or grandparents can start a 529 plan. In fact, anyone can set up a 529 plan on behalf of anyone. You can even establish one for yourself.
529 plans do not have annual contribution limits. However, contributions are considered completed gifts for federal tax purposes. In 2020 up to $15,000 per donor, per beneficiary qualified for the annual gift tax exclusion.
A Coverdell Education Savings Account — also known as an education IRA — is another type of savings account with tax advantages. The money invested into the account (with a contribution limit of $2,000 per year, per child) is allowed to grow through compound interest over the years to maximize the amount of money on hand when your child(ren) needs it.
The contributions you make into an education IRA are not tax deductible. You do have to pay income tax on the money before you invest. But the interest the account earns over time is not taxed and you don’t have to pay taxes on money you withdraw for qualified education purposes (including tuition, school supplies, books, fees, and basic room & board). The funds can also be used for certain K-12 education expenses.
UGMA & UTMA Accounts
These all-purpose savings and investment accounts are often used to save for college. They take the form of a trust. When you put money in the trust, you are making an irrevocable gift to your child. You manage the trust assets until your child reaches the age when the trust terminates (i.e., adulthood). At that point, your child can use the UGMA or UTMA funds to pay for college. However, once that age is reached, your child can also use the money to pay for anything else.
Since using a trust involves a complex set of tax rules and regulations, we strongly recommend working with a professional to set up and administer.