College tuition and the associated costs increase at 2x the rate of inflation. This increase is annual, and this trend appears to remain in the foreseeable future. While the government and private sources have been generous with loans, grants, and scholarships, there are other ways to reduce tuition costs by planning early.
This article will identify the tax-free investment vehicles for parents and grandparents to utilize for college tuition, but the efficiency of these options will differ for each investor. The investor’s financial position, lifestyle, and goals must be discussed with a certified tax consultant.
Tax-Free Investment Options
There are four popular tax-free investment vehicles to consider:
- 529 plans,
- Traditional and Roth IRAs,
- Coverdell Education Savings Accounts, and
- Custodial Accounts.
It is necessary and important to consult with a professional tax consultant to discuss the best investment option for you and the beneficiary.
College savings and prepaid tuition plans are types of 529s administered at the State level.
Contributions to 529 plans are made with after-tax dollars. For 2023, the annual exclusion is $17,000, or $34,000 for married taxpayers filing jointly. This maximum amount can be transferred by gift without incurring the Federal gift tax. However, the total maximum contribution to a 529 plan isState-specific.
There is an option to “superfund” a 529 plan by making five years’ worth of gifts in one deposit. However, the rules to superfund a 529 plan are narrow and specific, and the counsel of an experienced tax consultant is highly recommended.
The withdrawals for qualified education expenses are exempt from Federal income taxes. Tax-free withdrawals are offered in most States.
In December of 2019, the use of 529 distributions was expanded to include up to $10,000 of student loans and expenses relating to registered apprenticeship programs.
Traditional and Roth IRAs
Early withdrawals can be made from either a Traditional or a Roth IRA without incurring the 10% penalty if the funds are used for qualified college expenses. These expenses can be for the account holder, their spouse, children, or grandchildren.
It is important to note that the waiver only applies to the 10% penalty. The distributions from a Traditional IRA will be subject to Federal income taxes.
There are other drawbacks to consider when IRA contributions are used for college expenses. The funds cannot be replaced unless the account holder is employed. The distributions will be recognized as income on the following year’s application for financial aid. This can negatively affect the eligibility of the applicant.
Coverdell Education Savings Accounts
Coverdell accounts can be opened at banks or brokerage firms. Like 529s, the earnings are tax deferred, and distributions are tax-free when paying for qualified education expenses. These tax-free withdrawals are at the Federal level and available in most States.
However, unlike 529s, Coverdell distributions can be used to pay for higher, elementary, and secondary education expenses. Income taxes and a 10% penalty will be assessed if the withdrawals are used for non-qualifying expenses.
It is important to understand that Coverdell contributions are not tax deductible. All contributions must be made before the beneficiary turns 18. One beneficiary can have more than one Coverdell account, but the maximum annual contribution is $2,000 per beneficiary, not per account.
Custodial accounts are opened under the Uniform Gift to Minors Act or the Uniform Transfers to Minors Act. These accounts allow transferring money or other assets into a trust to benefit a child or grandchild.
The assets in custodial accounts are managed by the investor, as the trustee, until the beneficiary reaches majority age. This age is State specific.
When the child or grandchild reaches majority, they own the account and can use the money however they wish. These accounts are not limited to qualified education expenses.
The exclusion limit to avoid the Federal gift tax is the same as the 529 plans: $17,000 ($34,000 for those married filing jointly) in 2023.
A drawback to custodial accounts can be that the assets in the account are owned by the beneficiary, not the parents or grandparents. This will affect the eligibility for financial aid. Under the Federal aid formula for financial assistance, students are expected to contribute 20% of their savings, as opposed to the 5.6% expected of the parents.
It is wise to approach college expenses the same as retirement. For most American families, college tuition and expenses combine savings, scholarships, and grants. The advantage of choice is good, but choosing the right savings plan is an individual decision. The age, financial position, and the remaining productive years of employment of the parents or grandparents are and should be taken under consideration.
The benefits of each investment plan will be different for each investor.
If you need a professional and highly experienced tax consultation relative to college savings plans, please contact Anderson Bradshaw Tax Consulting today.
With over 30 years of experience, we have seen every tax issue and have learned the best ways to handle any situation quickly and efficiently.