A frequently asked question is, “How might I save for a child’s college education?” The answer depends on how much the education is expected to cost and how much time is left until the child heads off to college or university.
The amount of funds that will be required will depend upon whether your child will be attending a local college, attending a local college and then transferring into a university, or going straight to the university. If attending college locally, you generally only need to be concerned about tuition, and the child can live at home, whereas attending a university, unless it is local, will add the cost of housing and food on top of substantially higher university tuition. Another factor is whether the student will leave school after obtaining a bachelor’s degree or will be doing graduate studies for an advanced degree.
When the time comes, your child may qualify for a scholarship or grant, but you can’t depend on that when working out a college savings plan.
The federal tax code has two beneficial savings plans that can be used. In both plans, there is no tax benefit to making any contributions. The benefit is that growth due to appreciation in investments, if any, and earnings (dividends and interest) are tax-free when withdrawn for qualified education expenses. Thus, the sooner the plan is started, the better, because it will have more years to grow in value.
More tax benefit is gained by front-loading the contributions and thus having a larger amount on which to compound the growth and earnings. You should also be aware that anyone, not just you, can make a contribution to the child’s college savings plans. So if your child has any well-heeled grandparents, other relatives or friends who would like to help, they can also contribute.
The two savings plans currently available for college savings are the Coverdell Education Savings Account and the Qualified Tuition Plan, most commonly referred to as a Sec. 529 Plan (529 denotes the section of the tax law code that governs it).
Coverdell Education Savings Account – This plan only allows up to $2,000 in contributions per year, and although it allows withdraws for kindergarten education and above, the contribution limitations generally rule it out as a practical method for college savings.
Sec 529 Plan – This approach is likely your best option. State-run Sec. 529 plan benefits are limited to postsecondary education, but they allow significantly larger amounts to be contributed; multiple people can each contribute up to the gift tax limit each year without being subjected to gift tax reporting. This limit is $14,000 for 2017, and it is periodically adjusted for inflation; in 2018, it increases to $15,000. A special rule allows contributors to make up to five years of contributions in advance (for a total of $70,000 in 2017).
Sec. 529 plans allow taxpayers to put away larger amounts of money, limited only by the contributor’s gift tax concerns and the contribution limits of the intended plan. There are no limits on the number of contributors, and there are no income or age limitations. The maximum amount that can be contributed per beneficiary (the intended student) is based on the projected cost of college education and will vary between the states’ plans. Some states base their maximum on an in-state four-year education, but others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits in excess of $200,000, with some topping $370,000. Generally, additional contributions cannot be made once an account reaches that level, but that doesn’t prevent the account from continuing to grow.
When the time comes for college, the distributions will be part earnings/growth in value and part contributions. The contribution part is never taxable, and the earnings part is tax free if used to pay for qualified college expenses. In addition, the portion of the distribution that represents the return on the contributions and is used for qualified education expenses qualifies for the American Opportunity Tax Credit, which can be as much as $2,500, provided your income level does not phase it out.
For additional details or assistance in planning for a child’s higher education, please give us a call.