College savings plans are the answer to skyrocketing tuition. Education costs are rising at astonishing speeds; last year student loans overtook credit cards as the highest consumer debt. As college costs balloon it’s essential that you begin to prepare today for your children’s future expenses. There are 2 major vehicles for investing for tomorrow’s school bills – Cloverdell Education Savings Accounts and 529 College Saving Plans – luckily they are best used conjunction together.
Education Savings Account
The Cloverdell Education Savings Account(ESA) is a great tool that allows you to invest up to $2000 per year per child into the plan. Funds invested within the account grow tax deferred and then as long as the distributions are education related they are also tax free.
The $2000 maximum contribution applies both to the account holder and the beneficiary. This means that each beneficiary can only receive $2000 TOTAL from any ESA’s in a given year and also any account holder can only contribute a maximum of $2000 to any single beneficiary. If the account owner makes over $100,000 then a reduced contribution phase out begins up until $220,000 for couples and $110,000 for individuals at which point you are no longer allowed to contribute.
Once you put money into the plan it works very similarly to a Roth IRA where you can personally choose the types of investments you want: stocks, bonds and mutual funds. In addition to having full control over the investment allocation you can use the funds to pay for any education related expenses in Elementary School, Junior High, High School, College and Graduate School. ESA’s also allow funds to be used for off-campus housing, computers, tutors and other school supplies that are required by the educational institution.
If for some reason you need to pull the funds out of the account for non-school related expenses then you will be forced to pay income taxes plus a 10% penalty on the distributions. Unless the beneficiary receives a scholarship to pay for school then the 10% penalty is waived.
Distributions from an ESA must occur by the time the beneficiary reaches the age of 30 or else taxes and fees will be imposed however one great benefit of ESA’s is that they allow the beneficiary to be changed and transferred to other family members even up to first cousins. This is possible by rolling over the funds into a new ESA and setting up a different beneficiary.
Like an IRA you can make contributions for a specific year up until that year’s tax date – April 15. When it comes to the tax free distributions on approved expenses then you can also claim both the HOPE and Lifetime Learning Credit within the same year. Finally you can contribute both to a state sponsored 529 College Savings Plan and an Education Savings Plan within the same tax year.
Unfortunately as it stands right now unless Congress extends the benefits for 2013 only College andGraduateSchoolexpenses will be approved and the contribution limit will drop to $500.
If this happens then one of the two greatest benefits of the ESA – complete control over investments and being able to use the funds for expenses ranging from Kindergarten toGraduateSchool– will be removed. Not only that but with such a tiny contribution amount then any mutual fund fees and trading costs will severely impact returns.
529 College Savings Plan
A 529 College Plan is an investment vehicle set up by a state or educational institution that allows you to save for college and graduate school education. The 529 Plan is able to grow tax deferred and then if the funds are used for qualified college expenses the disbursements are tax free.
Unlike the ESA a 529 typically has no income or maximum contribution amount per year. Many states have lifetime contribution maximums in excess of $300,000.
The money in the plan is directed by the account owner however the available investment options are limited by the specifics of how it is set up. In many ways this is similar to how a 401K is run where you can direct the money yourself but you only have a limited number of mutual funds to choose from. Any Capital Gains earned during the life of the 529 Plan are allowed to remain tax deferred and fully tax free if spent of qualified education expenses. Annual tax management is very simple since 1099’s are only issued when disbursements are made.
529’s have a much more limited approved disbursement schedule than what Education Saving’s Accounts offer. Only expenses directly related to college such as tuition, books, supplies and limited support for room and board is allowed. However a great plus of the 529 is that approved disbursements are not calculated on the FAFSA as part of the base income for the following year’s financial aid application. Unlike the ESA there is no required disbursement date or time yet it is still allowed to switch beneficiaries during the life of the plan.
In addition to the favorable Federal tax treatment of the 529 College Plans many states offer incentives for residents and investors to contribute. In many states this are tax write-offs for the contributions and the withdrawals. Even though the Plan is set up by a state it is NOT required that the beneficiary go to school in the same state as where the plan was set up. Also you are not limited to investing in the Plan that is being offered by your state. As an example you could live inTexas, invest in aCalifornia529 and go to college inMassachusetts. Lastly the plans are considered as a Parental Asset even if the account is owned by the student and that makes financial aid that much easier to apply for because parent’s assets are rated at 5.64% of total assets as opposed to the students expected contribution of 20% of total assets.
In the end a combination between an Education Savings Account and a 529 Plan would be the course of action to take – assuming the rules get extended. Put the first $2000 into an ESA and the remainder into an appropriate 529 Plan.