As a parent, you naturally want to give your children every advantage to succeed in life. For many, this will include helping them with college — which is becoming more expensive every year. The good news is that you can begin saving for these expenses no matter what your child’s age. Perhaps the best-known way to do this is to set up a 529 plan.
The most common 529 plans allow you to accumulate savings in a tax-advantaged way. There is also something known as a 529 prepaid tuition plan, which allows a parent or guardian to purchase college credits today that can be used in the future, essentially “locking in” today’s (presumably) lower costs.
Both come with significant tax advantages — as long as the distributions are used to pay for qualified educational expenses or other forms of professional development. So for many families, setting up a 529 college savings fund makes the most sense.
What is a 529?
If the cost of college makes you gulp — and, not to scare you, but it should — you may breathe easier when you realize there is a way to save for college that could help you save on your tax bill too.
The answer is a 529 plan. The arcane name comes from the section of the Internal Revenue Code that created it.
Here’s everything you need to know about 529s.
TWO WORDS: TAX ADVANTAGES
When you use a 529, Uncle Sam will take less money so your children will have more for college.
Your contributions grow tax-deferred.
Withdrawals are free from federal income taxes as long as the money is used for “qualified college costs,” which include tuition, fees, room and board, books and even technology.
Your state’s 529 plan may offer, in addition, a full or partial state tax deduction, although this really varies by state. See how your state plan measures up to others with the plan comparison function at Savingforcollege.com.
While all 50 states and the District of Columbia offer at least one 529 plan, you’re not obligated to stick with your state’s plan, and your choice doesn’t have any impact on where your Studious Chloe or Jack eventually heads to school.
YOU NEED A CUSTODIAN The custodian, otherwise known as the account holder, is the person who opens the 529 plan and controls the money in the account. Typically it should be the child’s parent.
Here’s why: If you make your child the account holder, the assets in the account will be more heavily factored into federal financial aid formulas.
Translation: Your student may be awarded less financial aid.
Likewise, avoid having a grandparent as the custodian, since any distributions will be considered untaxed income for the student on financial aid forms.
The money has to be spent specifically on educational expenses for the “beneficiary,” so that’s where you put your child’s name. If you have more than one child, you might want to set up separate accounts for each.
IF YOUR CHILD DOESN’T GO TO COLLEGE
All that saving and your child picks a career that doesn’t require college?
Don’t worry, you can preserve the tax benefits by changing the name of the beneficiary, which is allowed once per year. You can designate any other relative — a lucky niece or nephew, perhaps — or you might decide that you’ve always wanted another degree.
If there’s no scenario under which you can use the 529 funds for educational expenses, all is not lost. You can still withdraw the money for any use, although you’ll have to pay the applicable income tax as well as a 10 percent penalty on money the fund earned. There are some exceptions to the 10 percent penalty, such as if the beneficiary becomes incapacitated. In addition, the penalty is waived if the beneficiary attends an academy that’s a branch of the U.S. service or gets a scholarship.
WHEN YOU SHOULD START SAVING? It’s literally never too early to start saving: If you sock away $250 a month in a 529 plan for your newborn, you’ll have nearly $100,000 saved for college when your baby turns 18, assuming a 6 percent annual rate of return.
But it’s also never too late, so even if your kid’s current wheels are more of the real Jeep variety than a battery-powered model, you still might want to look into the benefits of a 529.
529 College Savings Are Not The Only Option
Here are 3 alternatives to a 529 college savings plan you might want to consider.
COVERDELL EDUCATION SAVINGS ACCOUNT (ESA)
Available through brokerage firms, credit unions and banks, a Coverdell Education Savings Account (ESA), like a 529 plan, allows money to grow tax-free as long as you use the funds for qualified expenses. Unlike 529s, these accounts tend to offer parents and guardians a wider range of investments to choose from, including stocks, bonds, ETFs, mutual funds and CDs.
The drawbacks? You’re limited to a $2,000 annual contribution (per beneficiary), and if your income is too high ($110,000 for single filers, $220,000 for married couples in 2020), you will not be eligible to open an account. In addition, the beneficiary must use any accrued funds by the time he or she is 30 years old or will need to transfer the money to a new beneficiary or to a 529 account.
Uniform Transfers to Minors Act (UTMA) accounts and Uniform Gifts to Minors Act (UGMA) accounts are two types of custodial accounts you can open to save money for your child for any reason.
Your child is the ultimate owner of the funds held within these accounts; you act as the custodian of the account, managing the money until your child reaches adulthood and can take responsibility over the funds.
While Coverdell ESAs and 529 college savings plans offer tax benefits, UTMA and UGMA accounts do not. Contributions will not limit your income tax liability, and any appreciation in the assets will ultimately be taxed. Another point to know is that your Expected Family Contribution value, as determined by the information you provide if you apply for financial aid through the Free Application for Federal Student Aid or FAFSA, will likely be greater when you save in a UGMA/UTMA in lieu of a 529 plan or Coverdell ESA.
So why would someone choose to open one of these accounts? The main reason is flexibility: As long as the expenses are used to benefit the child, the funds can be used for anything. This means you’re not just limited to educational expenses and the minor has total control over the account assets after he or she reaches a certain age (which can range from 18 to 25, depending on the state).
ROTH IRA A Roth IRA isn’t a college savings fund at all — it’s a retirement account funded with post-tax money. As with most tax-a