With student loan debt averaging $37,000 per borrower, it’s no wonder education planning is top of mind for many parents. Creating an education savings plan will help your child (or family members) tackle higher education costs, and give you peace of mind about your their educational future.
A great first step is to familiarize yourself with the different types of education savings accounts .
The three main types of educational savings accounts are 529 plans, Educational Savings Account (ESAs, or "Coverdell" accounts), and brokerage accounts. While 529s and ESAs have tax benefits that brokerage accounts don’t, they have restrictions on contributions, investment choices, and qualified expenses. Weigh the pros and cons of each account type before deciding which is best for you.
Although you contribute after-tax dollars to a 529 plan, all growth in the account is tax free upon distribution if used for qualifying educational expenses. 529 Plans are state-sponsored, meaning each state has its own plan and manager. The details of each state’s plan will vary, but you have the option to select any state plan regardless of the state you live in.
Also, some states allow for state income tax deductions for 529 plan contributions. Click here to determine if you live in one of those states, and the potential amount of the deduction.
Some other defining characteristics of 529 plans include:
Anyone can open a 529 account, and anyone can contribute to the account (you, aunts/uncles, grandparents, and friends).
There are no income restrictions for opening or contributing to the account.
Typically, average contributions are $15,000 per year, per donor (i.e., couples can contribute $30,000 per year) to avoid gift taxes. However, you are allowed to superfund your 529 account (contributing an amount equaling 5 years of gift tax exclusion of $75,000 per donor) without gift tax consequences.
You can contribute an amount equaling 5 years of gift tax exclusion at once ($75,000 per donor).
You can withdraw up to $10,000 for K-12 tuition and student loan repayment.
The account opener is the permanent holder of the account and has the option to change beneficiaries within the family.
529 accounts can be kept open indefinitely, allowing unused funds to grow in the account and available to be used for another beneficiary.
If the funds are not used for educational purposes, a 10% penalty plus federal income tax on earnings in the account are applied upon withdrawal.
Education Savings Accounts (ESAs, Coverdell Accounts)
Educational Savings Accounts (ESAs) have similar tax benefits to 529 plans, however there are a number of notable differences. The biggest difference is that there are income restrictions on who can open the account: only individuals with adjusted gross income under $110,000 ($220,000 for couples) are eligible to open an ESA.
Other differences and a few similarities are listed below:
Anyone with an adjusted gross income within the limits can open the account, and anyone can contribute to the account.
Total contributions are limited to $2,000 per year until the beneficiary turns 18.
Account funds can be used for qualified education expenses and K-12 tuition without a $10,000 cap.
Account must be liquidated by age 30 or rolled over to another family member to avoid federal income tax and a 10% penalty.
A wider range of investment options are available.
The beneficiary becomes the account holder once they turn 18 years old with the freedom to use the money for whatever they want, however penalties will still apply if not used for qualified education expenses.
If the funds are not used for educational purposes, a 10% penalty plus federal income tax on earnings will be applied upon withdrawal.
Although there are no tax benefits with using a brokerage account, they can still be a good option to save and invest if you are worried about over funding a 529 plan. There are no restrictions on what the funds can be used for in a brokerage account, so if the child does not end up going to college there is no 10% withdrawal penalty.
Keep in mind that there could be capital gains taxes any time you sell investments in a brokerage account. Not to mention, if you decide that the purpose of this account is to pay for education, you will need to resist the temptation to use it for non-education expenses. The last thing you want is to come up short when it's time to pay the tuition bill!
Which account type is right for you?
While all three types of accounts are great ways to save for college, it is important you choose the one that is best for you and your family. Some questions you should ask yourself before settling on an account type are:
Do I expect my child/children to attend college? What if they don't?
Is the idea of potentially overfunding a 529 plan concerning?
How much might college cost by the time they are ready to go to school?
How much of my child's education am I willing to pay for? All of it, half, or a specific dollar amount?
What type of college might my child want to attend (Public In-State, Public Out-of-State, Private)?
There are quite a few variables to consider, so we strongly suggest seeking the help of a professional advisor to ensure you make the right decision .
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