The Basics of College Savings Planning (Part 1)

If you’re planning on your children getting a college degree, there are several things to think about. Where to go, what to study — and how to pay for it — are all likely top of mind. When it comes to the question of why they are attending college, today’s high school students seek higher pay, more job opportunities, and purpose-driven careers after college.

ALSO READ | The Basics of College Planning (Part 2)

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Getting Your Head Around the Cost

It’s rare to scan the daily news without seeing an article about the increasing cost of going to college. When you add up tuition, room and board, books, and other expenses, the total cost of a year at a public or private college may seem impossible to reach.

The College Board is a not-for-profit organization whose mission is to connect students to college opportunity and success. This organization has been serving for more than 100 years and is a key source for college costs. In its 2022 report, “Trends in College Pricing and Student Aid,” it reports that a moderate college budget for an in-state student attending a four-year public college in 2022-2023 averages $27,940.

For out-of-state students at public colleges, the average budget comes to $45,240. And for students attending private colleges, the average is $57,570. For some historical perspective, the College Board reports that over the past 10 years, tuition, fees, and room and board has gone up 2% a year for public four-year universities.

If you’re a parent with a baby, that means by the time your child is 18, it could cost nearly $40,000 a year for them to attend an in-state public university.

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College Savings Resources

A 529 Plan is an education savings plan operated by a state designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Code, which created these types of savings plans.

529 accounts can be used for college and trade schools and up to $10,000 of K-12 education costs including tuition, room and board at school, and a computer if required for your student’s classes. 529 accounts can also help pay down $10,000 of student loans per student.

529 Plans are established by states. Except for Wyoming, all states offer at least one 529 Plan. In addition, anyone can open a 529 Plan account: a parent, grandparent, or friend. And you can invest in a 529 of another state. The beneficiary can be anyone, even you. The only requirement is that the account owner be a U.S. citizen.

There are two types of 529 plans:

• Savings Plans work much like a 401k or IRA by investing your contributions in mutual funds or similar investments. Your account will go up or down in value based on performance.

• Prepaid Plans let you prepay all or part of the costs of an in-state public college education. This lets you lock in the tuition rate by purchasing units or credits. These plans are offered in only nine states as of 2023, and the credits can only be used for tuition. Read the plan details carefully, as some allow transfer to other schools, but your options can be limited

The person who opens the 529 account or purchases the prepaid plan owns the account, not the beneficiary, and always retains control. They decide how to invest the money contributed and how withdrawals are used and can change the beneficiary.

Contributions to a 529 Plan 529 Plans have no income limits, age limits, or annual contribution limits. Initial minimum contributions often start as low as $25, and then monthly contributions can be as low as $15 in some states. Most plans allow you to “set it and forget it” with automatic investments that link to your bank account or payroll deduction plans.

There are lifetime contribution limits, which vary by plan, ranging from $235,000 - $550,000 (as of June 2023). In 2023, contributions up to $17,000 per beneficiary per account owner qualify for the federal annual gift tax exclusion. You can combine five years of annual exclusion gifts to a 529 plan. You’ll need to file IRS Form 709 and check the box to treat the gift as spread over 5 years. It’s always smart to check with your tax advisor about estate or gift tax consequences of contributing to a 529 Plan if this could be an issue for you.

529 Plan income tax benefits Contributions to 529 plans are made with after-tax dollars. Although contributions are not deductible, earnings in a 529 plan grow tax-free and will not be taxed when the money is taken out for qualified education expenses. Additionally, over 30 states and the District of Columbia currently offer a full or partial tax deduction or a tax credit for 529 plan contributions.

Check with your state to see if your contributions qualify. If a withdrawal is taken for a non-qualified expense, the earnings portion will be subject to federal, and possibly state, income tax. Also, the earnings portion of withdrawals taken for non-qualified expenses may be subject to a federal tax penalty of 10%. There may also be state income tax penalties.

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Coverdell Accounts

A Coverdell Education Savings Account (ESA) is a taxpreferred savings and investment account to encourage people to save for future education costs. Compared to 529 accounts, they are considered a lower-cost account option and have a wider range of investment options, such as individual stocks, bonds, exchange-traded funds, mutual funds, and real estate investments.

There are some items to be aware of, including:

• The beneficiary of the Coverdell ESA must be under the age of 18 at the time the account is established.

• The contribution limit is $2,000 per beneficiary per year. When accounts are established by different family members for the same child, total contributions cannot exceed $2,000 in a year for that beneficiary.

• There is an income limit of $110,000 for individuals and $220,000 for married taxpayers filing jointly above which you cannot contribute to ESA accounts.

• The low contribution limit means even a small annual maintenance fee charged by the financial institution could significantly affect your ESA investment return.

• Your contribution goes into an account that will be distributed to your child at 30 years old if not used for college, unless the beneficiary has special needs. The earnings in the account will be income taxable and subject to a 10% penalty. You can change the beneficiary on the account or transfer the balance to another Coverdell or 529 plan, subject to certain rules.

Coverdell account income tax benefits Earnings in ESA accounts are tax-deferred, just like 529 plans. Similarly, if withdrawals are used for qualified education expenses, as defined by the Internal Revenue Service, they are exempt from federal income taxes. If a withdrawal is used for non-qualified expenses, then the earnings portion of the withdrawal is subject to federal, and perhaps state, income tax. Also, in most cases, the earnings portion of withdrawals taken for non-qualified expenses is subject to a federal tax penalty of 10%, though there are some exceptions.

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U.S. Savings Bonds Some or all the interest earned on U.S. Savings Bonds may be excluded from income if used for higher education. The bonds must be Series EE bonds issued after 1989, or Series I bonds. Bonds must be issued in the name of the taxpayer 24 years or older.

Qualified expenses include tuition and fees and contributions to Coverdell and 529 accounts, but do not include textbooks or room and board. It’s important to remember to pay the education expenses the same year you cash the savings bond, and you must claim the credit on that year’s tax return.

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UTMA and UGMA Accounts

Accounts set up under the Uniform Gifts to Minors Act (“UGMA”) and the Uniform Transfers to Minors Act (“UTMA”) have been used for many years to pay for college education. One advantage is that a portion of the earnings in these accounts may be either tax-free or taxed at the child’s tax rate. ($1,050 is tax-free, and the next $1,050 is taxed at the child’s rate).

Earnings above this initial $2,100 is taxed at the parent’s tax rate until the child reaches the age of majority. The disadvantage is that earnings are taxed at all (unlike 529 accounts). Another disadvantage is once the child is no longer a minor, they control the account and how the money is spent. Depending on the state, one is no longer a minor between the ages of 18 and 25. UGMAs and UTMAs can be rolled over into Section 529 Plans, but account control remains with the beneficiary once they are no longer a minor.

Some financial planners suggest spending down the account for the benefit of the minor first. When the UGMA or UTMA balance is zero, then use the 529 plan for their remaining education expenses. Please note these savings vehicles can be complicated, from both an estate planning and education funding standpoint. Please consult your financial planner, tax consultant, and estate attorney for more details.