Education is an excellent foundation for the opportunities and lifestyle we want for our children and grandchildren.
If you are saving for or want to contribute to a child’s education costs, you know it takes planning. There are several types of programs that can help by offering tax savings and other benefits to contributors.
529 College Savings Plans (Qualified Tuition Programs)
Qualified Tuition Programs — also called 529 Plans after IRS Code Section 529 — are state-sponsored. Every state sponsors at least one of the two types: Prepaid Tuition Plans and College Savings Plans. Both enable contributions to grow tax-deferred and withdrawals for qualified higher education expenses to be taken out free from federal (and usually state) taxation.
Prepaid Tuition Plans
Prepaid Tuition Plans enable you to lock in the tuition costs for a college at today’s rates. This can provide significant savings, especially for a child who is still quite young, since college costs continue to rise rapidly. However, prepaid tuition plans are limited to a specific school. To take advantage of the plan, a child must choose that school, apply to it, and be accepted. These are large assumptions to make.
College Savings Plans
College Savings Plans are not limited to a particular school or even to a specific state. They can pay for qualified higher education expenses for two and four-year colleges, graduate schools, vocational and technical schools. Qualified education expenses include tuition, fees, room and board, books, supplies, and any required equipment such as computers.
College Savings Plans generally have low commissions and low management fees. There are also no income limitations, making them available for use by high-net-worth individuals. They offer plan owners (the financial contributors) a significant amount of flexibility. Owners retain control of the assets and can:
- Change the investment strategy selection (generally once per year)
- Roll the account into another state’s plan
- Change the beneficiary, tax and penalty-free (funds can even be used for the account holder’s own education)
- Revoke the account
- Give up to maximum annual contribution limits that are higher than $300,000 in many states
- Contribute up to five years’ worth of gifts to a beneficiary in a single year without triggering the federal gift tax
The flexibility of being able to use this type of plan for any educational institution in any state and to be able to reassign the assets if one beneficiary does not use all of them makes College Savings Plans an excellent option. Adding in tax benefits that can have a significant impact on your savings plan makes them even better.
Alternatives to 529 Plans
Coverdell Education Savings Accounts (ESAs) and UTMA/UGMA Accounts are alternatives to Qualified Tuition Programs.
Like College Savings Plans, Coverdell ESAs are established with contributions that are not tax-deductible but are allowed to grow tax-free within the account. The withdrawals are free from tax or penalty if used for qualified education expenses. Uniquely, withdrawals can be used for elementary and secondary education, as well as for higher education, but other differences make them unsuitable for use by affluent families. There are income phase-out levels, and the annual contribution limit is relatively low ($2,000 in 2020).
The Uniform Gift to Minors Act (UGMA) and more recent Uniform Transfers to Minors Act (UTMA) allow parents to put cash and securities into a custodial account for a child, but these accounts do not have the tax benefits of other plans.
- The child receives full ownership of these assets at the age of majority.
- There are no limitations on the contributor’s income level or the maximum overall contribution.
- The account’s custodian may direct investments, but can neither revoke the account or change the beneficiary.
- Contributions are not state tax-deductible; only the first $1,000 of unearned income is exempt from federal taxation.
What Option Is Best?
Although any choice must suit the specific circumstances and goals of the individual or family establishing the account and the beneficiary, College Savings Plans have significant tax benefits that can help pay for college. They can also help affluent investors enhance their total portfolio’s overall tax efficiency or establish a family legacy tool.
It is essential to compare state plans to ensure that the fees are reasonable and that it includes enough variety in its menu of investment options. As with other investments, you want an appropriate diversification level and a risk profile that suits your goals and timeline.
For more details, read our White Paper. And ask a Kayne Anderson Rudnick Wealth Management advisor to help guide you in making the right choice for you and your family.
This report is based on the assumptions and analysis made and believed to be reasonable by Kayne Anderson Rudnick (“KAR”). However, no assurance can be given that KAR’s opinions or expectations will be correct. This report is intended for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. Past performance is no guarantee of future results.