If you have started to save for your child or grandchild’s college education, it’s worth considering whether to use a 529 plan, an education savings account, or an Irrevocable Trust.
Here’s what we think you should consider as you decide:
First, consider whether you want your offspring to have broader options than just the traditional college experience.
Since the start of the pandemic, college enrollments have declined by over one million students over the past two years, and with college tuition getting more and more expensive, many students are considering alternatives to the traditional higher education path.
Gap years, travel, trade programs, and online training are replacing the traditional college education path for many, and if you want that to be an option for your children or grandchildren, you should be aware that the traditional college savings plans may not be the right fit for your family.
Instead, consider whether it may make more sense to create an educational trust for your family, in which all of your children and grandchildren can benefit. More on that below in the section on education trusts.
Second, consider the financial aid consequences of how you are saving for college.
If you think your child or grandchild may need or want to qualify for financial aid, beyond student loans, the way you save for their education may significantly impact their ability to qualify. If your offspring will need financial assistance to pay for their education, it’s vital that the way in which you choose to save will not negatively impact their qualification for such assistance.
Third, consider the income tax consequences of how you are saving for college.
When you set aside money, unless you are saving for retirement in a qualified retirement plan, the income earned on that money is subject to income taxes. However, with various types of college savings plans, you can defer or avoid income taxes altogether.
529 Plans & Education Savings Accounts (ESAs)
Since 1996, 529 plans, which are named for Section 529 of the Internal Revenue Code, have been one of the most popular options for covering college costs. Congress expanded these plans to cover K–12 education in 2017, and it also changed the program to pay up to $10,000 in student loan debt in 2019.
One reason 529 plans are so popular is due to their tax-saving advantages. The money you contribute to a 529 account grows on a tax-deferred basis, and withdrawals are tax-free, provided they are used for qualified education expenses, such as tuition, room and board, and other education-related fees. And many states also provide a tax deduction or credit for 529 contributions.
Another appealing feature of 529 plans is their relatively high contribution limits. There is no limit on how much you can contribute each year, although if you contribute more than $16,000 (the amount of the gift tax exemption limit in 2022), you can trigger federal gift taxes and the requirement to file a gift tax return. If you plan to make a contribution close to or above $16,000, contact us for guidance.
Finally, with many 529 plans, you can set up an automatic transfer to add money directly from your bank account to your 529 account. Plus, many 529 plans allow automatic contributions as low as $25 per month.
Before you automatically save for your offspring’s future education using a 529 plan, keep in mind that to avoid paying taxes, plus a 10% penalty, the money must be used for eligible expenses only. Eligible expenses include tuition and fees, room and board, books, as well as computers and other items if they are required for classwork.
If your child decides not to go to college, you will pay income taxes, plus the 10% penalty in order to withdraw the funds and use them for something else. The other downside to saving for your child’s education in a 529 plan is that your investment options may be significantly limited to only a small selection of mutual funds.
Education Trusts
While 529 plans are quite popular, there is another way to save for your child or grandchild’s education through the use of an irrevocable trust. While there isn’t any income tax deferral on income earned by the assets held by these trusts, it is possible to structure a trust, so your beneficiaries could qualify for financial aid that they may otherwise be ineligible for with a 529 plan. If qualifying for financial aid would be even more valuable than savings on the income taxes owed on income earned by the trust.
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