So you’ve gotten that firstborn into college. You may be dealing with the separation well. The tuition bill? That’s another subject. Firstborn may be taken care of, but the siblings are lined up, cap and gown in hand, to graduate from high school in turn and set off. What to do?
Well, even if your child is still studying sandbox etiquette, there’s an important step you can take: using a 529 plan or Coverdell account, investment vehicles which allow funds to grow tax-deferred, and allow you to withdraw the money tax-free for qualified school expenses (not including student loans or interest on student loans).
There are many sponsors of 529 and Coverdell plans; costs and limitations may be different under different plans.
529 Plans
Named after section 529 of the Internal Revenue Code, these plans can provide an expedient way to save for college. The investments are handled by the plan, not the donor. The donor will not receive a Form 1099 to report taxable or nontaxable earnings until the year of withdrawals.
529 accounts generally have limited investment options, defined by the fund creator. Also, the cost of investing in a 529 plan will be determined by a plan sponsor. The cost is generally a function of both the costs of the plan sponsor’s management fee and the management costs of the underlying investment or the underlying fund expenses. Passively managed accounts (index or ETF accounts) are usually substantially less expensive than actively managed accounts.
The funds can be used for tuition, fees, books, supplies, and equipment required for study at any public or private college, university, graduate school, community college, or vocational school. The money can also be used for room and board, provided the beneficiary is at least a half-time student. Off-campus housing costs are covered up to the allowance for room and board that the college includes in its cost of attendance for federal financial-aid purposes.
Any distribution from a 529 plan not used for qualified educational expenses is subject to income tax and an additional 10% early-distribution penalty. The exception is if the beneficiary dies or becomes disabled or if the beneficiary receives scholarships and the funds become unnecessary. State treatment of such withdrawals will vary depending on the state and on the sponsorship of the plan.
With the recent change in the tax laws, though, from a federal standpoint, 529 plans can now be used to pay for tuition at private K-12 schools. However, not all the state plans have updated their programs to include this change. You need to look at the particular plan at the time of your contribution.
There are no annual contribution limits for 529 plans. However, there are maximum aggregate limits which vary by state. Nevertheless, contributions are considered gifts for tax purposes. Thus in 2018, contributions up to $15,000 each year for a single taxpayer or $30,000 for a couple can be made without exceeding the federal gift taxes. In addition, you can pre-fund the account for five years, so you can contribute $70,000 for a single taxpayer or $140,000 for a couple, as long as there are no additional gifts for the next five years.
Account owners maintain control over the account including the ability to use the money for purposes other than college if the need arises. The child cannot use the money for purposes other than education without the consent of the account owner.
Any U.S. taxpayer can open an account for the benefit of anyone. Though anyone can be a beneficiary of a 529 plan, it’s important to note that when changing the beneficiaries, the new beneficiary must be a qualified family member to avoid penalties. Qualified family members can be defined broadly, and can vary from one plan to the next, and can include children/stepchildren (and their descendants), brothers, sisters, nieces, nephews, aunts, and uncles.
A notable advantage of a 529 plan is that, although funds can be reclaimed by the donor (subject to tax and penalty on any gains), the assets are not counted as part of the donor’s gross estate for tax purposes. A 529 plan can be used as an estate planning tool to move assets outside of the estate while still retaining some control if funds are needed in the future. In some cases, estate taxes can be reduced without spending the money on education.
Because 529 college savings plans and prepaid tuition plans are treated as an asset of the account owner (typically the parent), they have little impact on a student’s eligibility for financial aid.
State benefits may change depending on the sponsor of the plan. Some states allow for gross income deductions for any contributions to a state-sponsored plan. Deduction amounts may vary by state. Some states, including Pennsylvania, recognize the benefits for offerings outside the state of record. Though the 529 offerings available in one state may differ from another, the basic structure and goals will be the same: the ability to put away funds in a tax-advantaged account to use for educational purposes.
In Pennsylvania, a contribution by a Keystone State resident into a 529 plan will be deductible for state income-tax purposes, but not for federal income tax. The contribution can be made to any 529 plan regardless of the state or origin of the plan. The deduction limit is up to the gift-tax annual exclusion amount of $15,000 in 2018 for a single taxpayer. Pennsylvania is one of a handful of states which recognize plans from across the country. In addition, Pennsylvania residents who file state income-tax returns in more than one state may see some impact on state credits for taxes in the other states. Investors in such a situation should consult with their tax advisors.
Two Suggested Funds
1) Vanguard’s 529, a Nevada-based plan, does not have enrollment fees, transfer fees, or commissions. Vanguard’s 529 investment options are geared to passive (index or ETF based) investing.
2) Schwab’s 529, based in Kansas, is similar to Vanguard’s, with no enrollments fees, transfer fees or commission fees beyond the program management fees and underlying fund expenses. These fees are similar to, but slightly higher than buying the funds on your own.
Coverdell Educational Savings Accounts
Named for its main proponent, the late Sen. Paul Coverdell (R-Ga.), and first used in 1997, these accounts are similar to 529 plans as a tax-advantaged investment account. They can be used for elementary and secondary education and can be used to fund either public or private secular or religious schools.
Contributions to a Coverdell account are limited to not more than $2,000 per year no matter how many Coverdell accounts have been established and the beneficiary must be under the age of 18 at the year of the contribution. Any individual (including the designated beneficiary) can contribute to a Coverdell as long as the contributor’s modified adjusted gross income is less than $110,000 for a single filer and $220,000 for joint filers. The ability to contribute up to $2,000 for any beneficiary is reduced on a ratable basis as the contributor’s modified adjustable gross income rises above $95,000.
Investment options for a Coverdell ESA account are closer to a self-directed IRA account, which provides a much larger selection of investment options.
There is an age limit; funds from a Coverdell account can also change beneficiaries to another family member once per year until the beneficiary turns 30.
Other Similar Plans:
Pennsylvania’s ABLE Savings Plan
529 ABLE savings plans are used primarily to pay for qualified disability expenses without impacting the eligibility to receive government benefits. Pennsylvania has a financial eligibility evaluation which entitles the state to weight the assets of a disabled individual while considering the distribution of public government benefits. This program is aimed at aiding those diagnosed with a disability before the age of 26 who are eligible to receive benefits under Supplemental Security Income and/or Social Security Disability Insurance.
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