Saving for your Child’s Education
*Parts I and II for Saving for your Child’s Education were posted at http://denverparent.net Check out Part I which was posted here on my website and if you want to see the comments for Part II, check out my post at denverparent.net. Here is Part II re-posted which addresses 529s and Coverdell ESAs. Part III addresses Custodial Savings Accounts and is posted at Denverparent.net for Financial Friday.
Last time, we talked about estimating how much you think your child will need for education and other expenses. This part of the series addresses 529s and Coverdell Accounts and in Part III, I will close out this series with Custodial Savings Accounts.
A comment on the last article was that an entire financial portfolio is important to maintain and this is definitely true but if you do nothing else, here are some popular ways to “invest” and save money for education:
First, there’s the 529 Plan, named after Section 529 of the IRS Code. For tax and other benefits, it is worthwhile to invest in a 529 in your state of residence but you could also invest in other states. Take a look at your state’s benefits because some states offer matching contributions and other incentives to residents of that State. There are two types of 529 plans- prepaid (only 11 states offer this and Colorado is not one of them) and savings. Prepaid plans allow you to purchase tuition credits at today’s rates to be used in the future. Savings plans are the most commonly offered and are different from prepaid in that all growth is based on market performance of the underlying investments- typically, mutual funds.
We have a savings 529 for both of our daughters, and we put yearly contributions in which are tax deductible (but only on our state of Colorado taxes). If we had 529s in another state, we could not get to deduct that on Colorado state taxes. Other benefits of a 529 plan is that the principal (the money you put in) grows tax-deferred and when your child receives funds for qualified college costs, that is also tax-exempt. For the parents who worry their kids will blow their savings on booze and drugs in college, worry not. The parents or the donor who established the 529 maintains control of the account so the college kids cannot withdraw as they please. If things are not going well, the donor can even reclaim the funds but subject to a 10% penalty unless certain conditions are met (see the link below to determine if you’d pay the 10% penalty). In some cases, if you do not spend the money on qualified expenses, you may also have to do a recapture with the State where you claimed a tax deduction so check your 529 and State rules before you make decisions to withdraw. Another advantage to 529 accounts, especially if you have multiple children, is that 529s are transferrable so if your son or daughter earns a scholarship or full-ride and decides not to use it, you can transfer it to siblings, parents, grandparents, and even to first cousins. There is no age-limit on use as long as the expenses qualify. Also, keep in mind that room and board is a qualified expense but if your child lives off-campus, then they only receive an amount up to what room and board at the University would have cost.
Like any investment or savings plan, there are pros and cons. Of course, the pros are discussed above but some of the cons are that you cannot, like investments, move the money around or choose where to invest it. The State or company that operates or owns the 529 plan can generally invest in mutual funds and you are limited by the IRS to only a single re- allocation or exchange per year. For example, in a 401K or IRA, you can change what you invest in (go from one of type of fund to another etc.), but in a 529, you get to only make this decision once a year. Another drawback to 529s is that it counts against you (the parent) or the kids when applying for financial aid so it is considered income. So, if you are planning to have your child apply for student loans or Pell and other Educational grants (if Congress does not eliminate them altogether here in this term), then, you may want the owner of the 529 to be a grandparent or immediate uncle/aunt who may not have kids of their own to avoid this account being counted as “income” for loan or grant purposes. Additionally, keep in mind if you are in the upper-income brackets, the federal tax regulations and rules limit how much money you can “gift” and 529s, are unfortunately, considered a “gift” and there are limitations and rules on that. Please check with your accountant if you plan to contribute $130,000 (married filing joint) over a 5-year period or $65,000 (filing single) over a 5-year period. Another con of this type of account is the fees you pay for management. Check your specific plan for fees. Fees should not be high and if they are, look at other options. As a general rule, the fees on the 529 plan should be lower than brokerage fees but if it is not, consider other options or do more research.
Procedurally, like any other account, you have to fill out paperwork. If you google 529 plans in Colorado, tons of options come up but talk with your friends and see what company they use. Fill out your child’s enrollment today and start contributing – you’d be surprised how helpful an account like this can be for the future.
A second popular option is the Coverdell Education Savings Account (ESA) or Coverdell ESA. Codified at Section 530 of the IRS Code, the Coverdell ESA provides the same tax benefits as the 529 Plan but a Coverdell ESA can also pay for elementary and secondary school education in addition to college. So, if you plan to pay for private schools, Coverdell ESA may be right for you and a good tax shelter for your money for the younger years of your child’s education. Just like the 529 Plan, the parents or owners (donors) of the 529 control the money so your children cannot tap into it and use it at will. Also, just like the 529, there is a transfer provision which allows the naming of new eligible beneficiary without taxes or penalties.
But, here are some important differences between the 529 Plan and the Coverdell: Coverdell ESAs have lower maximum contribution limits; currently only $2,000 can be contributed per year per child, while 529 plans generally have no restrictions on contributions, up to the maximum lifetime contribution. One of the biggest differences and advantages of the Coverdell ESA is that it allows almost any investment and a broader range including stocks, bonds and mutual funds while 529s are very limited. Another advantage and big difference is that you can move the money around several times a year and the same rules that apply to IRAs apply to ESAs. Another important difference is that there is no age limit to 529 plans so if the child decides to pursue post-graduate doctoral studies, the 529 can be used. ESAs must be disbursed on qualified educational expenses by the time the named beneficiary is age 30 in order to avoid tax implications and fees. Of course, the obvious difference is that Coverdell permits withdrawing for educational qualified expenses from elementary school and secondary school through college. 529s only allow university and college qualified expenses. Also, another big difference is that the income level of the donor may “phase out” contributions to the Coverdell ESA but will not affect 529s. Anyone can contribute to a 529 and there is no “phase out” for contributions.
Next time, in Part III, I will address Custodial Accounts– these can be a great tool and can be set-up in addition to the savings methods discussed above. The article is posted at denverparent.net as of Friday, April 1- check it out!
Disclaimer: All parts of this series were written by the author in her personal capacity and not attributed to her profession, or any organizations, employers, or the like that author is affiliated with. The author is interested in these topics and blogs for recreational purposes and not for financial gain. All views and opinions are of the author and not attributable to any company and not meant as an endorsement to any company or organization. Most importantly, author is not a financial expert, tax attorney, estate planner, or accountant, nor works in the financial planning field. This article is written solely for the purpose of sharing information and knowledge with the readers. All readers should consult with their own attorney, tax planner, financial or estate planner, and/or accountant prior to making investment decisions. The author is not liable and will be held harmless for any investment loss or risk undertaken as a result of opening any of the accounts aforementioned.