While school may be out for the summer, it’s never too early to start thinking about college savings options. In this blog post, we’ll explore a few options that can help taxpayers prepare financially for higher education.
Also known as qualified tuition plans or qualified savings plans, §529 accounts are specially designed to encourage saving for education costs. State agencies and educational institutions often sponsor and manage these tax-advantaged accounts. §529 accounts offer tax benefits that can make a significant difference in one’s savings journey.
With a §529 account, contributions grow tax-free, and when it’s time to make withdrawals, they’re also tax-free—provided that use of the funds are for qualifying education expenses. These expenses can include not only higher education costs but also elementary and secondary education expenses. From room and board to tuition, fees, books, supplies, special needs services, and even up to $10,000 of qualified student loan payments, §529 accounts may be used for a significant portion of education expenses.
It’s important to note that while contributions to §529 accounts are not deductible for federal tax purposes, some states offer tax credits for qualifying contributions. Depending on where a contributor lives and what type of account they open, there may be opportunities to benefit from some extra state income tax savings. However, contributors should be aware of the potential impact on financial aid. Colleges may consider the presence of a §529 account when awarding aid, so finding the right balance between tax-free growth and financial aid is key.
Another popular choice for college savings is a brokerage account. Designed for buying and selling investments, a brokerage account allows funds to accumulate through various means such as interest, dividends, capital gains, and market appreciation. However, when considering opening a brokerage account for a student, there is the Kiddie Tax to take into account. This tax regulation ensures that unearned income in the student’s account is taxed at the parent’s tax rate to prevent tax loopholes under certain conditions, such as the amount of the child’s unearned income for the year, their age, and their income tax filing requirements.
Educational Savings Accounts
Now, let’s talk about another option: Educational Savings Accounts (ESAs), also known as Coverdell Accounts. Similar to §529 accounts, ESAs allow earnings to grow tax-free. However, they come with some restrictions. The contribution amount is limited, and there are income phaseout thresholds. For example, single taxpayers contributing to ESAs must have a modified adjusted gross income (MAGI) under $110,000, or $220,000 if married filing jointly.
ESAs can be used for elementary, secondary, and higher education expenses. If the funds aren’t used for qualifying education expenses, there may be a 10% penalty on the growth, along with ordinary income taxation on the earnings. However, some exceptions exist where the penalty doesn’t apply, such as in cases of beneficiary death, disability, tax-free educational assistance, or attendance at a military academy.
Retirement Accounts and Insurance Policies
If you’re thinking outside the box, retirement accounts and insurance policies can also come into play. Withdrawing funds from Individual Retirement Accounts (IRAs) or taking an IRC §401(k) loan can be done penalty-free to pay for higher education expenses. These expenses include tuition, books, supplies, and equipment necessary for attending an educational institution. Some insurance policies, like universal or whole life policies, can also be tapped into to cover college expenses without incurring additional tax implications.
It’s important to note that while retirement funds and insurance policies aren’t typically disclosed on the Free Application for Federal Student Aid (FAFSA), they are included on the College Scholarship Service (CSS) profile. The CSS profile is maintained by the College Board and provides a more comprehensive overview of an applicant’s financial situation. This information can affect eligibility for nonfederal scholarships and other aid.
College savings options are plentiful and varied. Whether opting for a brokerage account, an ESA, or exploring retirement accounts and insurance policies, it’s crucial to understand the specific rules and regulations that apply. A little planning now can go a long way in securing a bright future for one’s education.
Chris Korban, CPA
Tax Materials Specialist, U of I Tax School
Rachel Szeklinski, CPA