As if navigating the retirement investing landscape wasn’t complicated enough, planning for your children’s college costs can seem even more challenging. Unlike your retirement, which may seem like ages from now, it might not be very long before your son or daughter turns 18 then heads off to his or her freshman year.
There are state-sponsored 529 plans, Coverdell accounts, UTMAs & UGMAs, heck you could even tap your own Roth IRA contributions to help cover college costs. You should also encourage your future college student to get up off their butt and work a part-time job so they have some skin in the game. That’s just our two cents though! Any way you slice it, it can turn into a complicated situation – particularly when it comes to taxes.
The most popular college savings account is the 529 plan. A 529 account is run by each state, but you don’t have to be a resident of the state to use it (as funny as that may seem). You want to find a state-run plan that has good investment options and has very low costs. Wouldn’t you know it, Michigan’s Education Savings Program is among the better ones in the nation. You can visit their website at MISaves.com.
But how are all of these plans taxed? After all, you want to get as much bang for your buck. Not only do you not want inordinate costs related to the plan and investment funds, but you should also be strategic about leveraging the accounts in a way that makes the most financial sense for you. Below is a summary of the primary college investing plans and their tax rules.
- 529 plan: these are designed specifically for saving for college. Earnings within the account grow tax-deferred and qualified distributions for educational expenses are tax-free. There are also gift and estate tax benefits – let’s say a grandparent wants to contribute to your son or daughter’s college fund – the grandparent could put in up to $75,000 per beneficiary each year and not pay gift tax.To capture the tax benefits, the 529 plan can be used for expenses such as tuition & books. There are other benefits too, such as being able to use up to $10,000 per year toward tuition for K-12 costs. Another benefit is if your child earns a scholarship, then you can withdraw up to the amount of the scholarship without penalty. For non-qualified expenses, however, distributions will be taxed and get hit with a 10% penalty.
- Coverdell (Education Savings Account): Like a 529 plan, earnings within the account grow tax-deferred and withdrawals for educational expenses are income tax-free. Perhaps the biggest drawback of the Coverdell account is that the contribution maximum is a paltry $2,000 per year. Another item to be aware of tax-wise is you cannot contribute to the plan if your adjusted gross income is above $110,000 using 2020 figures ($220,000 for married filing jointly). The IRS considers all non-qualified withdrawals from an ESA to be taxable income which will also incur a 10% penalty. The Coverdell also lacks in gift & estate tax benefits due to the low annual contribution cap.
- UGMA/UTMA custodial accounts: In general, UTMA/UGMAs have fewer tax breaks versus the 529 and Coverdell. There is a small benefit in that the first $1,100 of annual unearned income is tax-free, then the next $1,100 is taxed at the child’s rate (likely 0%). Income above $2,200 each year is then taxed at the rate of the trust. Custodial accounts are often used as a means to transfer wealth from an older generation to the younger generation while 529 and Coverdells are usually used just for college savings. There is more flexibility in that withdrawals can be made at any time for any reason so long as the money is used for benefit of the child.
- Roth IRA: This is kind of a work-around way of doing it. Since you can withdraw your Roth IRA contributions tax-free, penalty-free at any time, you can tap this account for your children’s college costs. We encourage you to leave your Roth IRA alone though. Keep your retirement on-track. Your son or daughter has his/her whole life to save, invest & pay back any student loans. You have just one shot at getting your retirement right.
Gameplan – As always, consider your situation first. If you are confident your child will attend a 4-year university and you want to assist with the costs, investigate 529 plans (the Michigan plan is a solid choice). For the priority of savings, you should have your retirement accounts contributed to heavily and have an emergency fund in place before college savings. Of course, if you have high-interest rate debt, pay that off before saving for college expenses. Also, coordinate with your child’s grandparents in case they are looking to pitch in, too. Once you have decided to save for college, start small and make it a routine – you can set up automatic transfers from your checking account to a 529 plan at most brokerages, you then want to invest it into a fund. Of course, TFC is here to take care of all of this for you.
Here’s the point
- College costs are daunting. Tuition, room & board, food, books, laptops, parties all add up (ok, maybe not that last one). Several account types can help you save & invest in a tax-advantaged way.
- 529 plans are the most common and generally offer some of the best benefits. Cash and investments in the state-sponsored plan grow tax-deferred and distributions for qualified educational expenses are tax-free.
- Coverdell accounts offer similar benefits, but these are less common due to the very low annual cap on contributions. For high-income filers, you may be ineligible to contribute to a Coverdell.
- UGMA/UTMAs are custodial accounts that are often used to transfer wealth from one generation to another. There is a small tax benefit based on earnings of the account and more flexibility for withdrawals.
- Roth IRA contributions should be considered a last resort option.
Action items
- It’s a maze of accounts out there, all with their own rules. We get it. Study-up on the accounts that can work best for your situation.
- Reach out to TFC to review or create a college savings plan tailored to your family’s situation.
- Prioritize your retirement before your children’s college savings.
- Save early and let compounding returns work in your favor!
Photo by Parker Gibbons on Unsplash