Education Savings Plan
Planning and saving for higher education can be daunting for many families given the rising cost of college. According to The College Board, the average per year cost of an in-state public university is $28,840. That’s more than $100,000 for a typical four-year education.
However, there are tools available to families that can make it easier to save and plan. Among them, education savings plans are the most common.
There are a few types of education savings plans and they are tax-advantaged, so any invested money grows tax-free. Examples of these savings plans include:
- Education Savings Account (ESA) – An ESA is a tax-advantaged account, so it grows tax-free, and it functions a bit like a Roth IRA. You choose an ESA to fund and depending on how the assets in that fund grow, so will your tax-free contributions. However, there are strict income and contribution limits ($2,000 max per year, per child).
- 529 plans – 529 plans are also tax-advantaged accounts with much higher contribution limits and no income or age restrictions. Though it varies by state, you can contribute at least $250,000 to the plan every year. This flexibility makes 529 plans a primary education savings tool, but you have to choose the right one. Every state has their own set of 529 plans, each with their advantages and disadvantages.
A financial planner or accountant can help their Texas clients identify the right 529 plan for their future student. - Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) – UTMAs and UGMAs are often a last resort for education savings, but they are an option if others are not available. They function like a mutual fund, and while there no contribution limits, the gift tax does apply. The primary concern with UTMAs and UGMAs is that the money can be used by the beneficiary however they please as soon as they turn 18 (or 21) – not necessarily on education expenses. This means you will have to trust your child to make the right decisions once they reach adulthood.
IRAs and Education
IRAs can also be an effective education savings tool. Normally, people are required to pay income taxes and a 10 percent penalty for early distributions should they take them out of the IRA prior to turning 59 1/2.
Qualified education expenses are a notable exception to this rule. If you take an early distribution to pay for any of the following, the 10 percent penalty is waived:
- Tuition and school fees
- Supplies required for class, including books
- Room and meals (only for student enrolled at least half time)
- Any additional costs due to special needs accommodations
You’ll still be required to pay income taxes on the earnings portion of the distribution.
Maximizing Education Savings
Maximizing education savings comes down to understanding how a 529 plan is best used. That, plus a little creativity. For example:
- Super fund your 529 plan – Normally, the gift tax kicks in when someone hits the exclusion limit ($18,000 for individuals, $36,000 for married couples) while contributing to a savings plan. However, for 529 plans, investors can contribute a lump sum up to five times the gift tax exclusion in a single year and spread it out over five years.
- Choose a 529 plan that allows for maximum control – There are many 529 plans to choose from, but some lock investors into inflexible terms that may put them at a disadvantage. For example, some plans automatically switch the assets the fund is invested in as the child ages. Ideally, you will maintain full control over the plan throughout its life.
- Use the remaining 529 plan’s funds for education expenses – In 2019, the SECURE Act added student loans to the list of qualified expenses that 529 plans could be used for. If there are remaining 529 plan funds available, they can be used to pay off loans.
In addition to fine-tuning your 529 plan approach, there are numerous ways parents (and their children) can maximize their savings, including:
- Have the future student get a part-time job (target jobs with tuition reimbursement benefits, if possible)
- Take advanced placement (AP) classes to earn some early college credits
- Take some (or all) college classes at a local or community college
- Pick a school that’s close enough that the student can live at home and commute to school
If you have access to additional income streams, such as rental income, this can also be used as a college funding tool. An accountant can provide ideas on how to do this with maximum efficiency.
Tax planning tactics can also be used to maximize education savings. They include the American opportunity credit, the lifetime learning credit, education savings bond program and deducting student loan interest.
Financial Aid and Scholarships
Many full-time college students receive some form of financial aid, including 87.3 percent of students in 2023. If savings cannot foot the entire bill, there are several ways to access additional financial aid, including:
- Scholarships – Scholarships are offered by numerous organizations, including federal and state agencies, professional organizations, businesses, churches and civic groups, among others. Scholarships may be based on academic merit, various talents, study in certain fields, or following a competition.
- Grants – Grants are also free money, in that they don’t have to be paid back. Grants are need-based and for most grants, applicants must meet some specific criteria. For example, students who lost a parent while serving in the Iraq or Afghanistan wars may be eligible for a federal grant.
- Loans – Ideally, your student won’t need loans to pay for education expenses, as they saddle graduates with debt as they leave school. If your student must go this route, federal loans usually offer better terms than private loans.
- Work-study jobs – Work-study jobs allow students to pay for some of their education expenses through part-time work. Work-study jobs may be on-campus or off-campus, and they must serve the public interest in some way.
In addition to the above, students can access additional financial aid through state assistance programs.
Balancing Education Costs
and Retirement Savings
Education is expensive, and so is retirement. Balancing their costs is a challenge that often leads to underfunding one or the other. If you are currently saving for both, there are some important considerations, including:
- Consult with an experienced accountant – There are many ways to allocate funds for education planning. An accountant will ensure you’re utilizing that money as wisely as possible to minimize your taxes, so your student has more to work with when it’s time for school.
- Don’t underfund retirement for educational expenses – Many families trade off their future retirement to fund near-future educational expenses, but this can cost everyone in the long run. First, every dollar robbed from retirement savings now will multiply over time. You could end up with hundreds of thousands of dollars less when you reach retirement.
Second, if your child doesn’t go to college, that’s a major opportunity cost in terms of retirement savings. In general, it’s best to have solid retirement savings before committing too heavily to education savings.
Maximize the benefits of tax-advantaged accounts – If you’re funding retirement and education at the same time, you may have several accounts to allocate your funds between. It’s critical to leverage these accounts and their tax benefits to the maximum, so there’s more money for both in the future.
Working with a reputable accountant, like Evident Pros, is an ideal way to plan for the future and determine the best options for your family.
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