Two ways to save for education costs

As the price of a college education continues to skyrocket, many parents (and grandparents) are looking for ways to save for future higher education costs. There are several taxpayer-friendly ways to save for a child’s or grandchild’s education. The two most popular options are Coverdell Education Savings Accounts (ESAs) and qualified tuition programs (commonly known as Section 529 plans).

Coverdell Education Savings Accounts (ESAs)

An ESA allows you to contribute money now for a beneficiary, such as a child or grandchild, to use later to pay qualified education expenses. Below are highlights of how ESAs work:

• Contributions are not tax deductible; however, the plan assets grow tax-deferred.
• Distributions, if used for qualified education expenses, are tax-free.
• Contributions can be made until the beneficiary reaches age 18. (Special rules apply if the beneficiary has special needs.)
• You remain in control of the account – even after the beneficiary is of legal age.
  • However, when the beneficiary (who is not considered to have special needs) turns 30, the funds in an ESA must be distributed within 30 days.
  • In this situation, upon distribution, the earnings may be subject to tax and penalty.

Major advantages

When compared to other education savings tools, ESAs offer one major advantage – the tax-free ESA distributions are not limited to higher education expenses. ESA contributions can be used to fund elementary and secondary school costs, such as tutoring and private school tuition.

ESAs can be established with numerous banks, mutual fund companies and other financial institutions. ESAs also allow customization of the portfolio, giving them a slight advantage over 529 plans. Plan assets can also be withdrawn and rolled over within 60 days of the withdrawal to another ESA for the same beneficiary — or certain members of the beneficiary’s family. The ability to change beneficiaries or roll over plan assets to another family member allows the funds within the ESA to grow for longer periods of time tax-free.

Annual contribution limits

The annual contribution limit is $2,000 per beneficiary. Keep in mind that the ability to contribute is phased out based on income. The limit begins to phase out at a modified adjusted gross income (MAGI) of $190,000 for married filing jointly taxpayers and at MAGI of $95,000 for all other filers. No contribution can be made once MAGI reaches $220,000 for married filing jointly taxpayers and $110,000 for all other filers.

Fortunately, the income phaseout can be easily avoided by having a child contribute to his or her ESA. Under this scenario, the child is considered to be the contributor and will not be subject to the income phaseout, assuming that the child’s AGI is below the $95,000 threshold.

Maximizing ESA savings

Due to the low annual contribution limit, maximizing your ESA savings begins with contributing every year in which you are eligible. The annual contribution limit does not carry over from year to year, so not contributing in 2016 does not allow you to contribute $4,000 per beneficiary in 2017. Be aware that the contribution limit applies on a per beneficiary basis.

Qualified tuition programs – Section 529 plans

Section 529 plans also allow you to contribute money now for a beneficiary, such as a child or grandchild, to use later to pay qualified higher education expenses. Below are highlights of how Section 529 plans work:

• There are two basic types of 529 plans – prepaid tuition plans and savings plans.
• Contributions are not tax deductible; however, the plan assets grow tax-deferred.
• Distributions, if used for qualified education expenses, are tax-free.
• Contributions can be made at any time during a beneficiary’s lifetime; the federal government imposes no age restrictions on 529 plans.
• The purchaser/custodian of the plan controls the funds until withdrawn.

Major advantages

Plan assets can be rolled over or transferred from one 529 plan to another. Any amount distributed from a 529 plan is not taxable if rolled over to another 529 plan for the benefit of the same beneficiary – or for the benefit of a member of the beneficiary’s family. An amount is rolled over if it is paid to another 529 plan within 60 days after the date of the distribution. In addition, the designated beneficiary can be changed without transferring accounts.

Another major advantage of 529 plans is that the IRS imposes no income restrictions on the individual contributors to the plans, as discussed further below.

Annual contribution limits

Contributions to Section 529 plans cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary. Contributions to 529 plans may have gift-tax consequences if the amount of contributions to a particular beneficiary exceeds $14,000 during the year. Contrary to ESAs, the IRS imposes no income restrictions on the individual contributors to 529 plans.

Maximize college savings

Consider contributing to both a Coverdell Education Savings Account (ESA) and a Section 529 plan to maximize college savings for children and/or grandchildren.

If gift and estate taxes have you concerned, you may want to consider making tuition payments directly to the educational institution. Payments you make directly to educational institutions are tax-free, and (if you pay the institution directly) you do not have to use any of your gift-tax exclusions or exemptions. Cash gifts to an individual are generally subject to the gift tax unless you apply your $14,000 per beneficiary annual exclusion or use part of your $5.49 million lifetime gift-tax exemption. Gifts to grandchildren are generally also subject to the generation-skipping transfer (GST) tax unless, again, you apply your $14,000 annual exclusion or use part of your $5.49 million GST tax exemption. So if you have cash you want to use to help pay for education expenses, it is more advantageous from a tax perspective to just write the check to the university instead of writing it to the child or grandchild.

If you’d like some help planning for upcoming college expenses, give us a call. It’s never too early to start.