In this article
- Section 529 plans
- Tax savings
- Investment risks
- Education IRAs
A college education is one of the best investments you can make for your child's future. But the high cost of college may alarm you -- especially if you've waited too long to begin saving. For example, a Coverdell Education Saving Account (formerly called the Education IRA), with its annual contribution limit of $2,000, won't offer much help if your child is already in high school.
Fortunately, there's another option for your college savings plan. State-sponsored college savings plans (or Section 529 plans, after the section of the Internal Revenue Code addressing them) allow some flexibility in choosing a school and the opportunity for late starters to make sizable investments while reaping tax breaks.
While there are two types of Section 529 plans, we only discuss one type here -- that is, Section 529 plans that allow you to set up educational savings accounts.
Section 529 plans allow individuals to invest in a predetermined pool of stock and bond investments. Most plans will require you to divide your investment according to a given asset allocation determined by your child's age. In general, the asset allocation will be more aggressive for younger children and less aggressive for children nearing college age.
Lifetime contribution limits to Section 529 plans vary from state to state, and you may have some flexibility on when you can contribute. In addition, there are no income thresholds and typically no annual contribution limits, although annual contributions of more than $14,000 may require filing a federal gift tax form and are subject to federal gift taxes. Contributions up to $14,000 annually ($28,000 when made jointly with a spouse) or a lump-sum contribution of $70,000 every five years will not incur gift taxes, up to the plan's respective lifetime contribution limit. Any earnings in the account potentially grow tax deferred. If you live in the state where the plan is administered, you may also be eligible for state tax deductions.
Once your child reaches college age, he or she may withdraw money from the account to pay for qualified higher education expenses. Assuming that you have followed the plan's rules, there will be no penalties, and withdrawals used for qualified education expenses are tax free. Any money left over in the account can be transferred to a sibling, first cousin or other family member (as defined by the Internal Revenue Code) of the original beneficiary without triggering gift taxes, as long as the new beneficiary is the same generational level as the original beneficiary.
Flexibility in contributions and college choice are the biggest advantages of Section 529 plans over other tax-deferred college savings vehicles. Even though these plans are state-sponsored, you do not need to be a resident of the state to participate, although you may lose out on state tax benefits by participating in an out-of-state plan.
Apart from tax savings, these plans offer the advantage of professional asset management. Each state contracts with a single asset management firm to oversee the plan, so by comparing various state plans, you'll be able to choose from several professional management companies.
The primary drawback to Section 529 plans is investment risk. Returns from Section 529 plans are not guaranteed. This means that your investment could lose value, perhaps just as your child is beginning college. Although the firms that manage Section 529 plans may use less-risky asset allocations to reduce risk as your child nears the first day of college, risk cannot be eliminated altogether.
You'll also want to have a thorough understanding of contribution and withdrawal rules before investing in a plan, since rules vary depending on the state. Pay particular attention to rules regarding transfers, early withdrawals, or withdrawals for things other than college expenses.
Section 529 plans are just one of the options you have for college savings. If you're getting a late start or if your child is unsure of which college he or she wishes to attend, a Section 529 plan may be your best choice.
However, if you've started saving and investing you may want to consider other options, including:
If you are eligible, these vehicles allow you to set aside $2,000 each year toward a child's education. Withdrawals for qualified higher education expenses are tax free for children under the age of 30, and account balances can be transferred to siblings without any tax consequences so long as it is done prior to the previous beneficiary's 30th birthday and the new beneficiary is under the age of 30. While tax benefits make these accounts attractive, the low contribution limit may not provide enough money to pay for college. Unlike state-sponsored plans, income limits apply for eligibility. Only single filers with incomes of less than $110,000 and joint filers with incomes of less than $220,000 are eligible.
As with any financial planning decision, the choice that's best for you will depend on your unique situation, including your risk tolerance and the number of years until your child begins college.
Another consideration is your child's plans. Does he or she even plan on attending college? If so, has he or she chosen a school? Talk with your child about college, then make an appointment with your financial professional to find the plan that best suits your needs.
- Section 529 plans are state-sponsored plans that allow savings to potentially grow, tax deferred, for college expenses.
- Withdrawals for qualified higher education expenses are tax free.
- You can contribute up to $14,000 annually or make a lump-sum contribution of $70,000 every five years, carrying the gift forward under your annual gift tax exclusion. Remaining account balances can be transferred to a sibling, first cousin or other family member (as defined by the Internal Revenue Code) of the original beneficiary.
- Section 529 plans offer flexibility in college choice.
- Each state plan has its own professional asset manager.
- Investment returns are not guaranteed.
- Consult your tax advisor before making any tax related decisions.
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