Two Intelligent Options for College Savings
If you are the parents or grandparents of a child of any age chances are good that the escalating costs of higher education are often on your mind.
Consider the following statistic; a recent study by Bloomberg found that since 1978 college tuition and fees have increased in price 1,225%. Over the same period medical care, another fast-ballooning source of costs, increased by just 634%, while inflation clocked in at a paltry 279%.1
What are the implications of this unprecedented increase in higher education costs? With costs rising this fast above inflation it seems apparent that students cannot count on bootstrapping their way through school by working summers to pay the entirety of their annual college bills.
At the same time, concerned parents and grandparents of soon-to-be students would be well served to take matters into their own hands by starting to save for college sooner rather than later.
What are the different ways of saving for higher education?
Fortunately, there are a variety of education savings plans available to students and their families. Unfortunately, each savings plan has advantages and compromises that may not be readily apparent, and plan selection is a financial decision with long-lasting consequences. As such it’s worth talking through all the options with your financial professional, but in the meantime here is a crash course in a couple of the most common plan types. There are two main savings vehicles specifically intended for college savings: the 529 savings plan and the Coverdell Education Savings Account, or Coverdell ESA.2
Coverdell accounts, also known as Coverdell ESA’s, allow after-tax savings to be set aside and grow tax-deferred. The proceeds of the account can then be withdrawn free of tax for qualified education expenses, including elementary and secondary school. As an added plus it’s possible to change the beneficiary to another eligible member of the family if circumstances change. Combined with the ability for these accounts to be invested in stocks, bonds and funds Coverdell ESA’s are a flexible way to set money aside for future education needs.
The downside is that contributions to these accounts are capped at $2,000 per year per child and eligibility to contribute phases out at higher income levels. Students considering expensive private school, graduate school, or with high net worth families may find alternative plans to be a better fit. The Coverdell value as an estate planning tool is also limited, as they are required to distribute assets by the time the beneficiary reaches age 30, limiting the power of compounding returns over time.
Advanced Ways of Saving for College: 529 plans
Since their introduction, these plans have served as flexible ways of saving for education. Section 529 plans also provide the ability to channel after-tax money into a dedicated education savings vehicle that allows for tax-free withdrawal for qualified higher education expenses. Section 529 plans can offer state income tax benefits, although rules and restrictions apply.
Unlike Coverdell accounts 529 plan contributions and gifts are not limited by income. A big advantage of 529 savings plans is that most have extremely high contribution limits. It’s possible to gift as much as 5 years of annual gifts (as described by the IRS) at once, allowing for $70,000 per person to be set aside immediately in a 529 plan. This allows parents and grandparents to invest a significant asset pool early and have it compound for many years. Since 529 plan earnings not used for qualified education expenses will incur both taxes a 10% IRS penalty it’s worth monitoring funding levels so as not to accidentally over-fund the account!
That being said, 529 plans allow for graduate studies, professional school, and beneficiary changes. While 529 plans are not capped by age, meaning that (when combined with the higher contribution limits) they are ideal for certain estate planning situations.
While the pros and cons of Coverdell ESA’s and 529 plans are complex and include factors not listed above, one thing is clear. Given the ever-rising costs of education, it makes sense for families to consult with their financial professional about the different saving options sooner rather than later.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.