Tax-Savvy College Savings Strategies

Prepare yourself financially for your children’s higher education costs with these tax-savvy college savings strategies.

With College Costs on the Rise, It Pays to be Prepared

If you have children or grandchildren and you’d like to help them pay for college in the future, it’s important to have a plan. College tuition costs have been rising at more than twice the rate of inflation in this decade, and that trend could continue. As we look ahead to the future, today’s toddlers, who will enter college around 2039, are projected to face annual expenses of approximately $38,429.51 for tuition, fees, room, and board at an in-state public school. For those aiming for private education, the yearly expenditure may reach around $88,311.81. So, no matter how old your children are, it’s never too early to start considering college savings strategies. Let’s explore a few below.

College Savings Strategies: 529 Plans

A widely utilized and tax-efficient method for saving money for college is the 529 plan. This investment plan provides tax benefits by allowing the funds to be used for qualified education expenses for a specific beneficiary. While contributions to the account are subject to taxation, the money invested grows on a tax-deferred basis, and withdrawals used for qualified expenses are free from federal taxes. As 529 plan contributions are considered gifts, the annual contribution limit aligns with the annual gift exclusion amount. The annual exclusion represents the maximum amount of money an individual can gift to another person without incurring gift tax. In 2023, the allowable gift per beneficiary is up to $17,000.

Although contributions are subject to strict regulation based on gift tax guidelines, there are strategies to navigate this limitation. Those with the resources to do so might employ a technique called “superfunding,” wherein they contribute five years’ worth of gifts at once, per person, without incurring gift tax. Essentially, parents or grandparents who have the means to do so could contribute $85,000 individually ($170,000 combined) when the child is young, allowing the funds to grow substantially over many years. This strategy ensures a substantial account balance by the time the child reaches college age. However, the rules surrounding this approach can be complex, so it is advisable to talk with a financial professional for guidance.

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College Savings Strategies: Coverdells

An alternative to a 529 plan is a Coverdell Education Savings Account (ESA), which operates in a similar manner. Within a Coverdell ESA, funds can grow tax-deferred, and withdrawals for qualifying education expenses are tax-free at the federal level and often at the state level, as well. These qualified expenses encompass not only college or university costs but also expenses related to elementary and secondary education. It’s important to note that if any withdrawals are used for non-qualified expenses, taxes must be paid on the withdrawal, along with a 10% penalty on earnings.

Contributions to a Coverdell ESA are not tax-deductible and must be made before the beneficiary reaches 18 years of age. While a beneficiary can have multiple Coverdell ESAs, there is a maximum contribution limit of $2,000 per year per beneficiary, regardless of the number of accounts.

College Savings Strategies: Traditional and Roth IRAs

An Individual Retirement Account (IRA) is a tax-advantaged savings account where investments such as bonds, stocks, and mutual funds are held. While IRAs are commonly associated with retirement savings, they can also be beneficial within college savings strategies. Particularly, the SECURE Act has made IRAs even more attractive for college savings by eliminating the age restriction on making contributions. This means that individuals can continue to contribute to an IRA at any age as long as they are still employed.

It’s also important to note that early withdrawals from an IRA to cover qualified higher education expenses for oneself, a spouse, children, or grandchildren are exempt from the 10% penalty, although income tax may still apply unless it’s a Roth IRA.

While utilizing retirement funds for a child’s college tuition is a viable option, it may not always be the most prudent choice. It is crucial to ensure that you have sufficient retirement savings outside of the IRA you intend to use, as withdrawing funds from retirement savings without the ability to replenish them can jeopardize your financial security in retirement. Additionally, it is important to consider that any distributions taken from an IRA will be considered as income on the subsequent year’s financial aid application, potentially impacting eligibility for need-based financial aid that your child might have qualified for otherwise.

College Savings Strategies: Custodial Accounts

Custodial Accounts, such as those established through the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA), provide a means to create a trust for a minor by contributing money or assets. As the trustee, you have complete control over managing the account until the beneficiary reaches 18 years of age. Once they reach that milestone, they gain ownership of the account and can utilize the funds for any purpose, not solely for educational expenses.

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In terms of contribution limits, technically, these accounts have no specific limits. However, to avoid triggering the gift tax, it is advisable to keep individual contributions below $17,000 annually. It is essential to note that these accounts classify the funds as the student’s assets rather than your own, which can impact your child’s eligibility for financial aid.

Implementing Tax-Savvy College Savings Strategies into Your Financial Plans

College costs continue to rise at an alarming rate, but there are options available to navigate this challenge. It is crucial to initiate early planning for your children’s college funds once you decide to provide assistance. College savings strategies like those listed above can assist you in preparing for the expenses associated with college education while also facilitating tax planning strategies.

If you have any questions or feel as if you would benefit from having a conversation with an advisor on the Arbor Capital team about how you can put a plan in place for your child’s education costs – one that doesn’t neglect your retirement plans – please contact us today. We look forward to hearing from you!

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