Story Published: Sep 12, 2013 at 9:00 AM PST
With the kids back in school, now is the perfect time to start thinking about College Savings Plans and to start doing a little tax planning as well. Certified Public Accountant Troy Reichlein explained the basics.
There are two types of savings plans for education expenses currently available and they are the Section 529 Plans and the Coverdell Education Savings Account (formerly known as an Education IRA).
Section 529 Plans are sponsored by States, State Agencies or Educational Institutions and consist of either a Savings Plan or a Prepaid Tuition Plan. Savings plans help cover college costs, while prepaid tuition plans lock in the rate of tuition charges when the time comes for your child to attend college.
Coverdell Accounts are less common, but allow tax-free earnings on contributions to be used for education expenses covering grades K-12 as well as college expenses.
Section 529 Plan
A Section 529 Plan is an account that is setup for a specific child (beneficiary) to accumulate contributions and earnings to pay for (or assist in paying for) their college education costs.
Contributions made to the account grow tax free while in the Plan, and provided the account funds are used to pay for education costs they are not taxed when distributed. You can direct the investments towards your level of investing philosophy, and investments can include CD’s, bonds, stocks, mutual funds, etc. Different states have different rules and investment options, so you need to do a little research on the options of your particular state. Once a 529 account has been established, contributions can come from anyone – parents, grandparents, friends, etc. – so they can be an excellent birthday fund as well!
Account balances have a maximum amount that can be obtained, which is indexed for inflation. Currently, the maximum account balance each beneficiary can have is $310,000 – which includes not only the contributions but also the earnings. Other than this $310,000 figure, there is no cap on how much can be contributed annually to a Section 529 account, but there can be other tax issues. Because the account is setup for a beneficiary, contributions to the account are considered ‘gifts’ for IRS purposes, and therefore, if a person gives more than $14,000 per year to a beneficiary, they will need to file a gift tax return. Keep in mind that the $14,000 is per person, so a husband and wife or grandfather/grandmother could give up to $28,000 per year.
There is also a specific allowance for 529 Plans that lets a contributor give up to a $70,000 gift all at once ($140,000 for married filing joint) and avoid any federal gift tax requirements, provided you make an election on your tax forms that spreads the gift out evenly over five years. This can be a very useful tool for estate planning.
While contributions to the Section 529 Plan are not deductible on your federal return, contributions to a 529 Plan in the State of Oregon do provide a deduction on the Oregon tax return. For 2013 the deductions are $2,225 for an individual and $4,455 for a couple filing a joint return.
So, say you have a newborn and want to setup an account, and fund it to get the maximum deduction on your Oregon return each year, which is currently at $4,455/year. You fund the account for $371 per month and say you earn an average rate of return of 6%. By the time your child is 18 you would have $144,427 in the account. You will have saved $20,842 in federal taxes (using a 25% tax bracket) and $7,503 in state taxes because the funds grow tax free, and you saved another $7,217 in Oregon income tax because of the annual deduction received on your return. Your total out of pocket expenses over the 18 years would be $72,973, and your total tax savings would be $35,562.
Oregon also has a 4 year carryover provision which means that if you (and/or a spouse) want to make a lump sum contribution one year, you could do up to $17,820 ($4,455 x 4) and then use the Oregon exclusion amount each year for four years. This option is great for people that receive large lump sum distributions such as from an inheritance or if they sell a house or other investment and want to make a large single-year contribution.
Eligible Expenses Include:
Room & Board (provided enrolled at least ½ time)
Computers/Laptops (only if the school requires them)
Books and Supplies (as required by school)
Financial Aid Consequences:
Effect varies by state. Some do not count at all, others count a percentage. It has been argued that contributions from persons other than parents do not count as assets for financial aid purposes.
If your child receives a scholarship you can withdraw that amount from the 529 account penalty free. You will still have to pay federal/state income tax on the pro-rata portion of investment earnings on that portion withdrawn, but you will not have to pay any federal/state penalty tax on it.
The risk of course is that you will have a child that does not attend college and therefore will not need the funds. If this occurs you can transfer to the funds a different beneficiary of the same generation (sibling, cousin, spouse of sibling, etc.) tax free, or, you can transfer it to the child of the original beneficiary so that they have funds available to them. There can be gift tax issues with the transfer to a grandchild, so you’ll need to talk to a tax advisor before you do it, but generally speaking the gift tax issues are typically insignificant for most people.
Finally, if you decide that you don’t want to transfer the funds and instead you want to buy that retirement condo in Maui you’ve always wanted, you can pull the funds out and pay the tax on them, plus the penalty taxes which exist for federal and state. Your original contributions are not taxable, so it’s only the earnings that you have to worry about, and the fact that they grew tax free for so long probably puts you back to the same spot as if they have been in a normal savings account all along.
Coverdell Education Savings Accounts
Coverdell accounts are not as popular as Section 529 accounts, and their options were almost severely restricted during the fiscal cliff crises earlier this year. Fortunately Congress and the President made the existing rules surrounding Coverdell accounts permanent meaning there is no sunset or expiration provisions on them anymore.
Coverdell accounts cover education and related expenses for grades K-12, as well as college expenses, and they cover public, private and religious schools.
Investment options are similar as those available in 529 Plans, and annual investments are limited to $2,000 per beneficiary. The contributions are not tax deductible, but as with 529 Plans they grow tax free.
The main benefit of a Coverdell account is that they cover expenses in grades K-12, and can then either be used for College expenses, or rolled over to a 529 plan. Covered expenses include:
Tuition & fees
Room & board (provided enrolled at least ½ time)
Books , supplies and equipment (scientific calculators, computers, laptops, etc.) required
Extended day programs (either before or after school)
The accounts must be terminated upon age 30 of the beneficiary, or death, and unused funds can be rolled over to 529 plans or distributed in a similar manner as a 529 plan.
A mix between both types of savings accounts can be very advantageous for families with young children. Strategic investments in a Coverdell account that are slightly more aggressive can provide tax free earnings for expenses while in grades K-12, while 529 contributions can focus more on long-term growth. Any unused Coverdell funds can then be applied to, or rolled into a 529 plan creating a very powerful vehicle for tax planning and savings.