Educational Savings Accounts
The gift of education is one of the most important gifts a child can receive in his/her lifetime. Whether it is for primary or secondary school, or college, this will generally be one of the largest expenses a family will incur.
Most parents are well aware of the rising costs of a college education. Recent budget shortfalls for many public institutions of higher learning have meant one thing – tuition is getting more expensive. With costs increasing it only makes sense to start saving early.
There are two savings alternatives which may be more attractive for parents and grandparents.
Alternative #1: Coverdell Education Savings Account (ESA)
Parents can contribute up to $2,000 per year per child and account contributions grow tax-free. Withdrawals are tax-free if the funds are used for qualified educational expenses (books, tuition, room and board) and can also be used for private schools (kindergarten through high school). Any monies used for non-qualified expenses (not related to education) are subject to federal income tax plus a 10% penalty on earnings. Once a child turns 18 years old, no additional contributions can be made. If any funds are not spent or the child does not go to college, the funds can be rolled over (tax-free) to a younger sibling. Any remaining funds not used by the time the child reaches age 30 will result in a distribution that must occur with earnings treated as ordinary income subject to income tax (federal), possible state tax, and a 10% federal penalty assessed.
Alternative #2: 529 College Savings Plan
These accounts have a lifetime (as opposed to an annual) contribution limit that varies by state. This applies to deposits and not the value of the account. The 529 funds can be used tax-free for qualified educational expenses similar to the ESA. Funds can be used at qualified educational institutions such as a college or university, junior community colleges, graduate schools, and accredited vocational schools. Even schools overseas can qualify for 529 funds. With the 529 plan, the child is known as the beneficiary and the parent (or the person who opens the account) is called the owner. The beneficiary does not have direct access to the funds; only the owner can request a distribution from the account. Earnings accumulate tax-deferred and distributions are tax-free when used for qualified expenses. If funds taken are not used for qualified educational expenses, the earnings will be treated as ordinary income with income tax (federal), possible state tax, and a 10% federal penalty assessed. In addition, the State of California assesses a 2.5% penalty on the earning portion of non-qualified distributions.
The SECURE Act of 2020 now allows 529 account owners the ability to use the funds to pay for student loan expenses up to a maximum $10,000 lifetime benefit for the beneficiary; up to another $10,000 on student loans held by the beneficiary's siblings; and for the costs of apprenticeship programs.
Some states may offer a tax credit for 529 plan contributions, but not all. Please check to see if your state is one of them. The State of California does not offer any tax credits for account contributions.
Additional Resources
- The College Board – http://www.collegeboard.com
- FinAid - The SmartStudent® Guide To Financial Aid – http://www.finaid.com
- U.S. Department of Education – student aid website – http://www.studentaid.ed.gov
- Saving for College – http://www.savingforcollege.com
- Begin early and seek professional advice.
529 College Plans: Investors should consider their investment objectives, risks, charges, and expenses associated with municipal fund securities before investing. This information is found in the issuer’s official statement and should be read carefully before investing. Before investing, the investor should consider whether the investor’s or beneficiary’s home state offers any state tax or other benefits available from that state’s 529 plan.
Contact one of our investment professionals to obtain more information.
