Education Planning

Analyze the tax benefits, ownership structure, risk and contribution limits involved in funding a child’s education

The ability to support a child’s education can be one of the most rewarding aspects of success. With rising inflation and high tuition costs, it may be necessary to start planning early for a contribution to another’s higher education.

For those seeking to contribute to the cost of higher education, there are a variety of investment vehicles and tax-efficient options.

To plan for your children’s education, you need the following information:

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529 College Savings Plan #

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions.

There are two types of 529 College Savings Plans

529 Prepaid Tuition Plans

Prepaid tuition plans permit a saver or account holder to purchase units or credits at participating colleges and universities (typically public and in-state) in exchange for future tuition and mandatory fees at current prices for the beneficiary. Most pre-paid tuition plans do not allow you to use them to pay for future room and board at colleges or universities, nor can they be used to prepay for elementary and secondary school tuition. Keep in mind that the rules for these plans vary State by State.

Prepaid tuition payments aren’t guaranteed, you may lose some or all of your money in the plan if the plan’s sponsor has a financial shortfall. In addition, if a beneficiary doesn’t attend a participating college or university, the prepaid tuition plan may pay less than if the beneficiary attended a participating college or university. It may only pay a small return on the original investment.

529 Education Savings Plans

An education savings plan allows a saver to open an investment account to save for the beneficiary’s future qualified higher education expenses – tuition, mandatory fees, and room and board.

In some states, education savings plans can also be used to pay up to $10,000 per year per beneficiary for tuition at any public, private or religious elementary or secondary school.

The key decision points for a 529 are the following:

  • In-state tax benefits. Some states offer tax benefits to residents contributing to in-state or out-of-state 529 plans.
  • Investment options. Typically, savers can choose from a range of investment portfolio options. Additionally, these portfolios can include static fund portfolios and age-based portfolios (usually referred to as target-date portfolios). When the beneficiary gets closer to college age, age-based portfolios generally shift toward more conservative investments.
  • Fees and expenses. Consider account management fees and management fees on underlying portfolios.
  • Plan performance. Review 1-, 3-, 5-, and 10-year performance figures when available.

Contributions to a 529 Plan

Many states offer in-state tax benefits for contributions to a 529 plan. These benefits may include deducting contributions from state income tax or matching grants but may have various restrictions or requirements.

In addition, savers may only be eligible for these benefits if you invest in a 529 plan sponsored by your state of residence.

Contribution Limits to a Plan

Generally, contribution limits don’t cross state lines. Contributions made to one state’s 529 plan don’t count toward the lifetime contribution limit in another state. But check the rules of your state’s plan to find out if that plan takes contributions from other states’ plans into consideration when determining if the lifetime contribution limit has been reached.

Currently, most states have contribution limits of $500,000 or more (and most will increase their limits every year as college costs rise). Regardless of the type of 529 plan: prepaid tuition or college savings, a state’s limit will apply. If the account value (including contributions and investment earnings) reaches the state limit, further contributions will not be accepted.

These limits are per beneficiary, so if you set up another account for your child in the same plan, your combined contributions can’t exceed the plan limit. If you have accounts in more than one state, ask each plan’s administrator if contributions to other plans count against the state’s maximum. Contribution limits generally do not cross state lines. A contribution to a 529 plan in one state does not count towards the lifetime contribution limit in another state.

Withdrawals from a 529 Plan

Withdrawals from 529 plans are not taxed at the federal level as long as you understand and follow all the rules for qualifying expenses. You’ll have to report your 529 plan spending to the IRS, so keeping careful records is important.

Qualifying expenses

  • Tuition and Fees for full and part-time students can be paid with 529 plans
  • Room and Board expenses
  • Technology (e.g. computer, printer, and internet service)

If you use 529 account withdrawals for qualified higher education expenses or tuition for elementary or secondary schools, earnings in the 529 account are not subject to federal income tax and, in many cases, state income tax. However, if 529 account withdrawals are not used for qualified higher education expenses or tuition for elementary or secondary schools, they will be subject to state and federal income taxes and an additional 10% federal tax penalty on earnings.

Does investing in a 529 plan impact financial aid eligibility?

While each educational institution may treat assets held in a 529 account differently, investing in a 529 plan will generally impact a student’s eligibility to receive need-based financial aid for college. You may also need to consider how having money in your 529 account for future qualified higher education expenses might affect financial aid for your student’s elementary or secondary school tuition. For many families, the larger part of a financial aid package may be in loans. So, the more you can save for school, the less debt you or your student may have to incur.

UGMA/UTMA Custodial Accounts #

A custodial account is a financial account that is in one person’s name but is controlled by another person. A custodial account is usually a managed account that an adult opens on behalf of a minor. Account control passes to the beneficiary once the child is no longer a minor.

Who controls the custodian account?

Money in the account belongs to the child, with the adult acting as custodian until the child reaches a certain age (between 18 and 25, depending on the state), at which point the assets must be transferred to the child. The custodian controls all investment decisions until the beneficiary reaches the minimum age of control. The custodian cannot change the beneficiary of the account. Withdrawals can be made at any time by the custodian, but they must be for the benefit of the child.

Who can contribute to a custodial account and are there limits?

Contributions to a custodial account are unlimited, so they make great gifts for major milestones and celebrations. Parents, grandparents, friends, and other family can contribute to them. The amount an individual can contribute free of gift tax in 2022 is $16,000 ($32,000 for a married couple).

Irrevocable gift Money put into a custodial account belongs to the child—it’s called an irrevocable gift. At the age mandated by the state, the custodian (often a parent) must transfer control to the child. At that point, they can do whatever they want with the money.

The gift tax may be a consideration There’s no limit to the amount you can put into an UGMA/UTMA. But gifts to an individual above $16,000 a year per individual ($32,000 for a married couple) typically require a form to be completed for the IRS. Also, any amount in excess of $16,000 in a year must be counted toward the individual’s lifetime gift-tax exclusion limits (the federal lifetime limit is $12.06 million per individual in 2022).

Realized earnings are taxable Earnings are subject to taxes. Income from investments is considered unearned income by the IRS. For children, unearned income above $2,200 is taxed at the rates used for estates and trusts. If interest and dividend income comes to less than $11,000, the parent can include that income on their return.

Little control over how the money is used Once the assets are transferred, the child can use them for any purpose. Each state has different rules for determining when the child must take control of the account.

Financial aid may be impacted Financial aid can be adversely affected by custodial accounts. They are considered assets owned by the child.

Coverdell ESA Plan #

The Coverdell Education Savings Account (ESA) has a $2,000 per year limit until the beneficiary’s 18th birthday. Contributions are not tax-deductible, and there is also an income cap which can limit who can contribute to one of these accounts.

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