September 21, 2022
A College Savings primer
After increasing at twice the rate of inflation for decades, college costs have stabilized somewhat since the beginning of the pandemic. However, with private and even state schools (for out-of-state students) running upwards of $75,000/year, paying for college is challenging for everyone. Most people use a combination of three strategies to cover the costs: using college savings plans, paying from cash flow, and taking out loans. This article will focus on the first of these, college savings plans.
There are three types of tax-advantaged college savings accounts: 529 plans, prepaid tuition plans, and Coverdell education savings accounts (Coverdell ESA.) The most appropriate plan for you depends on your situation, but with all three types, the tax advantages are greater the earlier you make contributions, as that money has more time to accumulate tax-free. They also share the same drawback: if the funds are distributed for non-qualified expenses, they are subject to a ten percent penalty in addition to any applicable income tax.
529 plans were originally limited to post-secondary education costs, but with the passage of the Tax Cuts and Jobs Act in 2017 and the SECURE Act in 2019, funds in these accounts can be used to cover not only college tuition but also K-12 education and apprenticeship programs, as well as student loan repayment. They are state-sponsored, with the District of Columbia and forty-nine states offering plans. (Wyoming does not offer a 529 plan.) For federal tax purposes, additions to these plans are not deductible when they’re contributed, but that money can be invested and withdrawals for qualified education expenses are tax-free. Many states, including New York and Oregon, offer state income tax deductions for state residents making contributions to their state-sponsored plans. You may open accounts with a plan in any state, so you’ll want to do your research to determine the plan with the best investment options and lowest costs. You’ll also need to decide whether you prefer to set up and manage the plan investments yourself or have an advisor do that for you.
Contribution limits vary based on individual plan rules. You can contribute up to the annual gift tax exclusion amount ($16,000 per individual for 2022) without having to file a gift tax return. It is also possible to front-load the funding of a 529 plan by giving up to 5 years’ worth of annual gifts at once (for a total of up to $80,000 per person, per beneficiary in 2022). You will need to elect to spread that gift out over five years, but as long as the annual average is under $16,000, and you remain under your annual lifetime exemption amount. (Most people do), you should not incur any gift taxes on the contribution(s).
Investment Options and Fees
Investments offered within each plan vary by state. For example, Virginia uses American Funds while Washington state offers both age-based and static investment options with investments in Vanguard and Dimensional. It’s important to research investment performance and fees prior to opening accounts. Morningstar does annual reviews and rankings of each plan, as does SavingforCollege.com.
Prepaid Tuition Plans
As the name implies, prepaid tuition plans allow you to purchase college units at today’s cost – usually with some type of premium. They are offered by eight states, including Washington, and are typically tied to the cost of tuition at the most expensive public university in the state. Although the value of the units is tied to the cost of a public school in that state, the funds can generally be used at any accredited college in the country. Unlike traditional 529 plans, funds in a prepaid plan cannot be used to pay for elementary and secondary schools.
The University of Washington won’t let you purchase more than four to five years of credits for any one student. As with a 529 plan, if you fund the account with more than $16,000 in a calendar year, you’ll need to file with the IRS to elect that the gift be split over several years.
Prepaid tuition plans don’t offer investment options. The state manages the investments, and your rate of return matches the rate of college tuition inflation in that state. In Washington, college tuition increases are tied to the rate of wage inflation. Purchasing prepaid units through the GET plan is similar to purchasing a state-backed bond. It’s a less aggressive, more stable approach than investing in stocks within a 529 plan.
Coverdell Education Savings Accounts
Coverdell accounts are similar to 529 plans, providing for tax-free growth on assets invested in the fund when they are withdrawn for qualified education expenses. Prior to the passage of the Tax Cuts and Jobs Act, Coverdell ESAs were the only way to save for K-12 education.
Annual contributions are capped at $2,000 for joint filers with a modified adjusted gross income (MAGI) up to $190,000 and are gradually reduced for MAGI between $190,000 and $220,000. Couples earning over $220,000 and individuals earning over $110,000 are not eligible to contribute to Coverdell accounts. Contributions cannot be made for students over the age of 18.
Investment Options and Fees
Coverdell ESAs are not tied to specific states or fund families the way that 529 plans are, so they do offer more options for investing. Generally, any investment available through the custodian where you’ve opened the account is eligible and there are no plan fees; you’ll just pay the internal fund fees and any advisor fees if you use one. If you qualify based on income limitations and would like greater investment options, a Coverdell ESA may be a good choice.
With all of these savings methods, it’s best to start saving early – preferably as soon as the child is born or adopted. Time is the greatest asset; the longer the account can grow and compound, the better. As always, your Fulcrum advisor is here to help you determine the best approach, depending on your situation.
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