The average cost of a college degree at a public university is close to $10,000 per year and rising rapidly. If you’re like most families, you don’t have that much extra room in your budget each year. Instead, you can use a specialized college savings account to save in advance for your child’s education.
Two of the most common types of educational accounts are 529 plans and Coverdell Education Savings Accounts which offer a different blend of benefits and drawbacks. By understanding your account options, you can select the right one for your situation – and be one step closer to sending your child to their dream school.
An Overview of 529 Plans
Qualified tuition plans – more commonly referred to as 529 plans – are tax-advantaged educational savings accounts sponsored by a state, state agency, or other group authorized by Section 529 of the IRS code. These plans are extremely popular due to high contribution limits, generous tax benefits, and flexible uses.
Contributing to a 529 Plan
There is no income restriction or annual contribution limit to a 529 plan, but each state imposes a lifetime contribution limit per beneficiary. These limits are based on the anticipated cost of college in the state and range from $235,000 to over $550,000.
Uses of 529 Plans
The funds in a 529 plan can be used to pay for qualifying expenses for your child’s college – including tuition, books, and lodging in some cases. After a legal change in 2020, qualified education expenses now include costs associated with a registered apprenticeship program and up to $10,000 in student loan repayments. In many states, you can also use the money in a 529 plan to fund up to $10,000 per year in K-12 schooling.
Tax Benefits of 529 Plans
Contributions to a 529 plan are not tax deductible at the federal level, but many states – including Alabama – offer deductions. However, state deductions are often limited. For example, Alabama residents can deduct up to $5,000 per year from their taxes or $10,000 for a married couple.
While state tax deductions are certainly a boon for those who qualify, the main benefit of a 529 plan is that withdrawals are not taxed as long as they are used for qualified educational expenses. This means that investment earnings in the account are never taxed when they are used to pay for tuition and related costs.
529 Plan Investment Options
Investment options vary based on the plan and sponsor, but you typically have access to a variety of mutual funds and ETFs inside a 529 plan. However, most plans prohibit you from purchasing individual stocks or bonds and often impose limits on how often you can change investments.
Options For Unused Funds in a 529 Plan
If your child does not use the funds in their 529 plan for education, you have three options. First, you can transfer them to another beneficiary, such as a younger child. Second, your child can roll the funds into their Roth IRA, assuming they meet the qualifying criteria. Lastly, you can withdraw the funds for non-educational purposes, but you or your child must pay tax on the earnings and often owe a penalty.
An Overview of Coverdell Education Savings Accounts
Like 529 plans, Coverdell Education Savings Accounts [ESA] are tax-advantaged accounts designed to help you save for your child’s education. These accounts are waning in popularity due to low contribution limits and strict income limitations for savers.
Contributing to A Coverdell ESA
To contribute to a Coverdell ESA, your income must be below $110,000 or $220,000 if you are married filing jointly. If your income is below the threshold, you can contribute up to $2,000 per beneficiary in a given year.
Uses of a Coverdell ESA
The funds in a Coverdell ESA can be used to pay for higher education expenses as well as private K-12 schooling. Unlike 529 plans, there is no annual limitation for tax-free withdrawals to pay for private elementary or secondary school.
Tax Benefits of Coverdell ESAs
Contributions to a Coverdell ESA are not tax deductible at the federal or state level. However, withdrawals from a Coverdell ESA are not taxable as long as the funds are used for qualified educational expenses.
Coverdell ESA Investment Options
One benefit of a Coverdell ESA over a 529 is the range of available investment options. These accounts allow you to invest in individual stocks and bonds as well as mutual funds and ETFs.
Options For Unused Funds in a Coverdell ESA
If your child does not use the funds in a Coverdell ESA for education expenses, you can withdraw the money and pay tax plus a penalty. You also have the option to roll the funds into a Coverdell ESA for another beneficiary. However, rollovers from a Coverdell ESA to a Roth IRA are not permitted.
Which College Savings Account Is Right for You?
The right educational savings account for you will depend on your unique situation and goals. A 529 plan may be the right choice if you are a high earner or want to take advantage of state income tax breaks. You may also favor a 529 plan if you want to contribute a high amount per year or want to give your child the option of rolling unused funds into a Roth IRA.
On the other hand, you may favor a Coverdell ESA if your income is below the applicable threshold, and you prefer to invest in individual stocks. Additionally, a Coverdell ESA may be a more attractive option if you want the flexibility to take unlimited withdrawals for K-12 schooling.
Other Options for Educational Saving
While 529 plans and Coverdell ESAs are the main types of accounts specifically designated for education savings, you have other options to pay for your child’s college as well. You can consider a custodial account – like a UTMA – a loan from your 401(k), or even parental loans to help your child cover the costs of their education.
An experienced financial advisor can help you weigh the benefits and drawbacks of each educational saving option and choose the right one for your situation. Your advisor can also help you balance competing financial objectives, like saving for your own retirement while helping your child pay for college.
Plan For Educational Expenses with Meld Financial
When you partner with Meld Financial, our experienced advisors can help you choose an educational savings account that matches your goals and work with you to incorporate college savings into your overall financial plan. We accomplish this through our comprehensive wealth management program – Financial Fingerprint™ – which helps you plan for all your financial goals including saving for your child’s education.
Our team of tax, legal, and financial professionals can also help you choose investments to grow your child’s college fund and even balance competing savings goals. With Financial Fingerprint™ and a partnership with an experienced advisor, you have the tools to send your child to their dream school without compromising your financial future.
Contact us today to learn more about Financial Fingerprint™ and get started.
