College costs can take a toll on a family’s financial earning power if steps are not taken beforehand to save for and fund this expensive endeavor. With college costs ranging from $20,090 to $45,370 annually, finding the best sources of funding is important.
Educational Savings Accounts Basics
There are several factors connected to educational savings accounts that are pertinent to choosing the best type of account for a family’s particular financial needs.
- Eligibility – Single taxpayers with adjusted gross income of up to $95,000 and married couples with an adjusted gross income up to $190,000 are eligible to contribute up to $2,000 per year for every beneficiary into an educational savings account. The beneficiary must be under age 18 unless they have special needs. For those who are over the adjusted gross income limit, the contribution amount is gradually reduced to zero.
- Deductibility – Any contribution to an education savings account is not deductible. However, the earnings grow tax-deferred and, if used to pay for the beneficiary’s post-secondary education expenses, are also distributed tax-free.
- Distributions – For any qualified education expense incurred by the beneficiary during the year, the amount of the distribution equal to or less than the qualified expense, is not included in gross income. However, if the distribution amount exceeds all qualified expenses for the year in which the distribution was made is included in gross income.
Qualified education expenses for which non-taxable withdrawals can be used include expenses for higher education, qualified elementary and secondary schools, whether public, private, or religious. Expenses such as tutoring, room and board, uniforms, computers, and extended day program costs can be included.
The AOTC or Lifetime Learning Credits are coordinated with the tax exclusion for Education Savings Account distributions. This means that both can be used in the same year, as long as the credit and exclusion cover different expenses.
If total distributions exceed the qualified higher education expenses in a year, the portion that is over the expense is included in income and may be subject to a 10% penalty tax.
Qualified State Tuition (Section 529) Programs
As with any educational savings account, qualified state tuition programs often referred to as Section 529 programs, eligibility, deductibility, and distributions have certain restrictions and limits.
- Eligibility – For any contributions to a qualified state tuition program, commonly known as a Section 529 plan, there are no income or age restrictions.
- Contributions – States vary on the maximum amount that can be contributed to a Section 529 plan, but the amount can be substantial. For example, states such as Colorado, Florida, Georgia, Illinois, Iowa, Kansas, Kentucky, Massachusetts, Michigan, Minnesota, Missouri, Nebraska, Nevada, North Carolina, Ohio, Oregon, Rhode Island, Tennessee, Vermont, and Virginia currently have an annual maximum contribution limit of $14,000. All states have a sizeable account balance limit varying from $100,000 to over $500,000
- Deductibility – Although contributions to an educational savings account are not deductible for federal income tax purposes, six states allow contributions to be deducted from state tax returns: Arizona, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.
- Distributions – Distributions are either qualified or non-qualified. Qualified distributions are expenses such as tuition, fees, books, supplies, computers, and computer technology. Any expenses that is used to pay for educational expenses are allowed. Free from federal income tax, these distributions can come from state-sponsored and privately-sponsored tuition plans. Non-qualified distributions are subject to a federal income tax plus a 10% penalty tax.
- Flexibility – There are several flexible aspects to a Section 529 plan, such as:
- The donor remains in control and decides when withdrawals are taken and for what purposes.
- Amounts from one Section 529 plan to another can be rolled over tax-free once every 12 months without the need to change beneficiaries.
- States that offer prepaid tuition plans usually allow the value of the plan to be transferred for use at an out-of-state or private school.
- The qualified beneficiary of the plan can be changed at any time.
- Although subject to an income tax and penalty tax, non-qualified withdrawals can be made from the plan for any purpose.
- These terms were made permanent by the Pension Protection Act of 2006.
Educational Funding Action Checklist
There are several areas to analyze when determining the funding of a child’s future education.
- Decide how much of a child’s education is going to be funded.
- When thinking about the type of school a child will be attending (private or public), select a target annual educational cost to fund.
- The degree that inflation will play in the increase of costs in the future.
- When the child enters college, estimate the total educational fund that will need to be available.
- Not including any amounts already accumulated, determine the amount that must be systematically saved, based on the assumed interest rate, in order to reach the funding goal.
- Evaluate and select the best educational funding plan that includes the available education tax incentives and savings vehicles.
- Pledge to deposit money into the savings plan on a regular basis.
If possible, start from the day a child is born. According to The Simple Dollar, saving $50 per month, a family can accumulate $20,000 by the time a child turns 17-years old, with an average 7% return on investment.
Family and friends can give a gift directly to a 529 college savings plan by using the website GiftofCollege.com.
Have a portion of each paycheck deposited directly into the educational savings plan. Many people do not miss the money if it is taken out before they “see” it in their paycheck.
No matter what type of savings plan is chosen, the important point to remember is that every dollar that is saved is one less dollar that a child will have to borrow when attending college. Discuss all plans for any future college expenses with a qualified financial planner who can guide a parent through the various types of savings plans and help families decide which type of plan is the best fit for their family’s financial situation.