College Savings Plans

Background

According to businessinsider.com, tuition at public four-year institutions has increased 213 percent in the past 30 years. To help your child start off their adult life without a mountain of debt, it’s worth considering which college savings plans can effectively help you save for their education. Of course, it’s best to start as early as possible, but where should you be putting the money? Fortunately, there are tax advantaged ways to prepare for this important expense. The College Savings Plan and the Coverdell Education Savings Account both offer a pathway forward.  

College Savings Plans

What is the difference between a Coverdell ESA and College Savings plan?

  1. The ESA has an annual contribution limit of $2,000. College Savings Plans typically have a set maximum balance established by the program, which varies by state and ranges from $235,000 to $520,000.
  2. The ESA has an income limit for maximum modified adjusted gross income of $190,000 for married couples filing jointly and $110,000 for single filers. The College Savings Plans have no income limits. 
  3. Contributions to an ESA must be made before the beneficiary turns 18. Additionally, the funds in the account need to be used before age 30. There are no age restrictions for a College Savings Plan.
  4. An ESA account holder can invest in almost anything, including individual stocks and bonds, real estate investment trusts, mutual funds and exchange-traded funds. Most College Savings Plans are restricted to designated mutual funds.                                                                                      Source: smartasset.com

“Do not go where the path may lead, go instead where there is no path and leave a trail.”

Ralph Waldo Emerson

College Savings Plans

College savings plans are state-run.  As far as investments go, College Savings Plans generally offer a variety of investment fund options, similar to a 401(k). There are usually some static investment options, as well as some that adjust their asset allocations over time. The Internal Revenue Code was modified in 2015 to allow more education-related expenses such as the purchase of computers and up to $10,000 annually in K-12 tuition.

Both College Savings Plans and Coverdell ESAs are after-tax­ accounts, like Roth IRAs. This essentially means you don’t get a current-year federal tax deduction for your contributions, but any qualifying withdrawals will be 100% tax free, and your investments will grow and compound tax-free while in the account.

Having said that, because of the state-operated nature of College Savings Plans, many states do offer a current-year state tax deduction for contributions. For example, South Carolina allows residents to deduct contributions to the state’s plan, while some, like Arizona for example, allow residents a deduction for contributions to any state’s College Savings Plans.

It’s important to mention that you don’t necessarily have to contribute to your home state’s College Savings Plan. College Savings Plans plans are extremely flexible investment vehicles. They usually have lifetime contribution limits and you may contribute up to $75,000 per benefactor ($150,000 for a married couple) in a single year without the money being subject to the federal gift tax. There are no restrictions on the income of the participating family or the age of the beneficiary. Contributions need not be listed on your federal tax return and deposits of up to $15,000 annually qualify for the gift tax exclusion.

A big advantage of College Savings Plan is that most have extremely high contribution limits. For example, the South Carolina Future Scholar College Savings Plan has a $426,000 contribution limit which should be enough to cover most college educations. 

Coverdell ESA: 

A Coverdell Education Savings Account, or Coverdell ESA, is the other main option designed to help Americans save for college. Unlike College Savings Plans, Coverdell ESAs are not state-run. 

The upside to this is that while a College Savings Plan is structured like a 401(k) when it comes to investment choices, a Coverdell ESA allows you to invest in virtually any stock, bond, or mutual fund you want. If you want to invest some of your kid’s college fund in a single stock, a Coverdell ESA allows you to do it.

Coverdell ESA funds can also be used to pay for qualified educational expenses at any level — in other words, if you sent your child to a private high school, you could use money from a Coverdell to help pay for it.

Withdrawal Penalties and Fund Transfers

If you don’t spend the money on college-related expenses, prepare to get burned. Not only will you owe taxes on any earnings within the amount you withdraw, but you’ll have to pay the federal penalty—10% of your earnings. Plus, certain states may impose an additional 10% penalty on your earnings, bringing the potential fee as high as 20% of the amount you withdraw. Non-qualifying withdrawal penalties are waived if the beneficiary earns a tax-exempt scholarship, attends a U.S. Military Academy, dies or becomes disabled.

One nice plus is that with both of these accounts, you can switch the beneficiaries among other members of your family.

That includes the beneficiary’s spouse, child, grandchild, stepchild, sibling, step-sibling, parent, grandparent, stepparent, niece, nephew, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law—or any of these relatives’ spouses—as well as any first cousins.

This is also nice in case one child doesn’t use all their savings,  You can then just transfer to the other child.