The total average cost of higher education now exceeds $140,000 per child at private four-year colleges.¹ That cost can exceed $70,000-$75,000 a year at select schools — a number that continues to explode. But there are several ways young students and their families can start saving for college. Here we introduce a few popular savings options and dig deep into the one embraced by many parents — the 529 Plan.
Two Simple, Early Options to Start Saving for College
According to Sallie Mae,³ 61 percent of families have no plan to save for college. Among those who are saving for college, more than half use general and retirement accounts rather than specific college savings plans. It is true that some savings is better than none but a specific college savings plan offers a number of advantages. Here are two options:
UTMAs (Uniform Transform to Minors Accounts) are considered the granddaddy of college savings accounts as they protect assets for minors until they reach the age of majority in their state. Depending on the state, every child under 19 years old (or 24 for full-time students) who files as part of their parents’ tax return is allowed a certain amount of “unearned income” at a reduced tax rate: The first $1,000 is tax-free as it is offset by the standard deduction. The next $1,000 is taxed at the child’s tax rate. Amounts greater than $2,000, however, are taxed at the parent’s rate.
A Coverdell ESA, or Educational Savings Account, is a trust or custodial account created for the purpose of paying the education expenses of the designated beneficiary. The account allows you to make an annual non-deductible contribution to a special investment trust account. It can then grow federal tax-free until used for qualified education expenses. The limitations of Coverdell ESAs include a $2,000 annual contribution cap and that contributions do not provide state income tax deductions.
What Is a 529 Plan and What Types Are Available?
While UTMAs and ESAs have their place, 529 Plans (named after Section 529 of the Internal Revenue Code) were added as an option in 1996 to deliver a better college saving option. Earnings in 529 plans accumulate on a tax-deferred basis and distributions are not taxed when used for qualified higher education expenses.
Additionally, many states offer state income tax deductions for contributions made to state 529 Plans. For example, a married couple filing jointly can contribute up to $30,000 in Pennsylvania and deduct that amount from state income taxes. For this reason, 529 Plans now form the #1 investment saving vehicle for college.
529 plans can be broadly grouped into two categories:
College Savings Plans work much like a retirement account by investing your after-tax contributions in mutual funds or similar investments.
Prepaid Tuition Plans let you prepay all or part of the cost of an in-state public college education. They may also be used for private and out-of-state colleges using a conversion process.
Benefits of 529 Plans
- Unsurpassed Income Tax Breaks
Although contributions are not deductible, earnings in a 529 plan grow federal tax-free and will not be taxed when the money is taken out to pay for college. Other savings vehicles, such as mutual funds, will give up a portion of their earnings to annual income taxes and also get hit with a capital gains tax at withdrawal.
- Your State May Also Offer Tax Breaks
Besides federal tax savings, over 30 states currently offer either tax deductions or credits for 529 plan contributions.(4) Since you can generally claim state tax benefits each year you contribute to a 529 plan, it usually makes sense to continue making 529 deposits until the last tuition bill is paid.
- You Stay In Control of the Account
With only a few exceptions, the named beneficiary has no legal rights to the funds in a 529 account. This provides assurance that the money will be used for higher education. In contrast, the child takes control of UGMA/UTMA custodial accounts when he or she reaches legal age.
- Everyone Can Take Advantage of a 529 Plan
Unlike Roth IRAs and Coverdell Education Savings Accounts, 529 plans have no income limits, age limits or annual contribution limits and lifetime contribution limits can be as high as $520,000, depending on the plan. Those looking to reduce estate taxes can elect to treat a 529 plan contribution of between $15,000 and $75,000 as if it were made over a five calendar-year period to qualify for the annual gift tax exclusion.
Maximizing School Aid
If you’re applying for financial aid you need to know how these accounts will affect your bottom line. The issue is that the federal financial aid formula treats assets and income differently, and also treats the student’s money differently from that of other relatives. The differences show up starkly on the Free Application for Federal Student Aid (FAFSA), which all students seeking aid must fill out.
For financially independent students who hold their own 529 plan, need-based aid is reduced by a maximum of 20% of the plan’s value. That means $50,000 in a college-savings plan reduces financial aid by $10,000. In contrast, 529 plans owned by parents reduce need-based aid by a maximum of 5.64% of the asset’s value. That means if you have $50,000 in a college-savings plan for your son or daughter, their aid would only be reduced by roughly $2,800.
Finally, grandparents looking to contribute to their grandchildren’s education are in luck – at least for a year. Why? 529 plans held by grandparents (or non-custodial parents) don’t show up on the FAFSA as assets. Therefore, they do not impact the initial financial aid offer. However, any money withdrawn to pay for college gets reported on the student’s next year’s financial aid form as untaxed income – and can reduce future aid by 50%. This means that withdrawing $10,000 for freshman year will reduce the aid received for the sophomore year by $5,000.
We know what you’re thinking – that’s a lot to remember. Start by checking out some of our helpful tips for filling out the FAFSA, or Free Application for Federal Student Aid. Because saving for college can be complex we invite you to talk to a professional at Magellan Financial to structure a plan that works for you.
The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates The material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.