Certain educational savings programs can offer tax benefits when saving for education. Before beginning to save, a benefactor must ask themselves, can I afford to invest in someone else’s education? And how can I save?
Can I afford to invest in someone else’s education?
Generally, there are two main groups of people who want to save for a dependent’s education; parents who are also saving for their own retirement, and grandparents closer to or already in retirement. Both groups have to ask themselves the same question— can I afford this? Since many retirees are on a fixed income, a decision can be made by simply looking at their budget and seeing if they can support a beneficiary’s college savings. Of course, they should always be mindful of how it may affect their future income.
For people who are still working or saving for retirement, the decision is more difficult. Since there are more savings goals to meet — retirement planning, ensuring you have rainy day fund, paying off debts — you will need to prioritize. Unlike saving for retirement, there are many different options for your beneficiaries to fund the rest of their education. Education savings should be seen as, and treated as, a gift to the student, not as an obligation. If your savings can only cover part of their tuition, financial aid, work-study, and loans can help offset the difference.
How can I save?
There are two different types of programs designed to offer tax benefits when saving for education. These are Section 529 Plans and Coverdell ESAs. Although we are focusing on these plans for the tax benefits involved, there are other vehicles for saving should you decide neither of these options are for you.
Section 529 Plans
Section 529 plans are state operated investment plans that give families a way to save for college with tax benefits. There are two basic types of 529 plans: prepaid tuition plans and college savings plans.
Prepaid tuition plans generally allow college savers to prepay for tuition at a state sponsored college or university. Most plans have residency requirements. The concept is that if you pay for tuition at today’s rates, the child will be able to attend in the future, regardless of how much higher the tuition may be.
College savings plans allow a contributor to establish an investment account for a student for the purpose of paying the student’s qualified college expenses. A typical plan allows for investing in mutual funds, and withdrawals can generally be used at any college or university regardless of the state carrying the plan or the state of residence.
Investing in a 529 plan can offer important tax benefits. Although contributions are made with after-tax money, earnings in 529 plans are not subject to federal tax*, and in most cases, state tax, so long as withdrawals are made for eligible college expenses. In most plans, residents that invest in their state’s 529 plan are offered an income tax deduction or credit for a portion of their contribution.
Any adult can open a 529 plan for a future college student. A donor may contribute a maximum of $75,000 ($150,000 if married) in a single year for each 529 plan beneficiary without gift tax consequences**. This represents a five-year advance on the 2018 $15,000 gift tax exclusion. These numbers are subject to change, and were verified on the IRS website as of September 12, 2018.
More information for the 529 plan offered by your state can be found on their website, a comprehensive list of websites can be found here here .
Coverdell Education Savings Accounts
Coverdell ESAs operate similarly to 529 plans in that they provide an account that will grow tax deferred with investment earnings that can be distributed tax-free for qualified educational expenses. Some key differences include contribution limits of $2,000 per year per child until the child’s 18th birthday, no state income tax deduction for contributions, and tax-free withdrawals are permitted for private elementary and high school expenses, in addition to college expenses. After the Tax Cuts and Jobs act signed in late 2017, Section 529 plans can now distribute to K-12 institutions like Coverdell ESAs but each state’s 529 plan may have its own restrictions.
Coverdell ESAs are offered by individual brokerage firms, much like an Individual Retirement Account (IRA), with considerably more investment options than Section 529 plans. Look to see if your preferred brokerage firm offers Coverdell accounts for further details.
For more information regarding various options for saving for college, please visit the following website: http://www.finra.org/investors/saving-college
Next Steps
After choosing the account that best suits you, your next focus will be funding the account. For this, best practices are similar to those for saving for retirement. Saving early, saving consistently, and monitoring your progress toward your goal are all key factors in optimizing the education savings experience. Many accounts will let you set up automatic contributions, which will let you take a “pay yourself first” mentality, similar to automatic contributions to a 401(k). There is also an option of a single lump sum contribution that you can let grow over a long period of time. An additional strategy is to contribute only incidental income—the income that you have not budgeted for, including bonuses and gifts. Finally, you can decide to do a combination of the methods above, a larger lump sum followed by smaller recurring contributions and supplemented by incidental income. Whichever path you choose, there are many options when planning for education.
The landscape of investing for education expenses can seem complex, and there are many options available. Break down your planning phase into separate steps, and move one step at a time, and things become a bit simpler. Take an objective look at whether or not assisting someone with their educational expenses is viable. When choosing the account that will best suit you, take a step back, understand the options available. Most of all move forward with the option with which you are most comfortable. When deciding on how much to contribute to these accounts, remember that it is a favor, not an obligation, and don’t harm yourself in helping your beneficiary. Finally, remember to utilize the resources you have available to make the best decision possible for you and your beneficiary.
If you have any questions, please reach out to me directly. John McAuliffe, john@raffawealth.com
*RWM is not qualified to provide tax advice and nothing in this article should be construed as personal advice or tax advice. Consult a tax professional before implementing any ideas expressed in this article.
** RWM is not qualified to provide estate planning advice and nothing in this article should be construed as personal advice or gifting advice. Consult an estate planning professional before implementing any ideas expressed in this article.
Disclosures
All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this material, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. The descriptions and explanations contained herein should not serve as the sole determining factor for making investment decisions. All information is obtained from sources believed to be reliable, but Raffa Wealth Management does not guarantee its reliability. Information pertaining to Raffa Wealth Management’ advisory operations, services, and fees is set forth in Raffa Wealth Management’s current disclosure statement, a copy of which is available from Raffa Wealth Management upon request. Past performance is not indication of future results and any investment can lose value.