Let Uncle Sam help you pay for college
As the kids head back to school you may be wondering how you will ever afford their college education.
A four-year education in a public university currently costs about $55,000, and a degree from a private university costs $132,000. In 15 years, these costs are estimated to rise to $316,000 for four years at a private university and $133,000 for a public university.
Since educational expenses are not tax deductible, if you are in a combined state and federal tax bracket of 35 percent, the required before tax income to pay for these expenses is $486,000 for a private college and $205,000 for a public college.
Let's look at two approaches to college savings where Uncle Sam can help pay these large expenditures.
529 College Savings Plans - 529 College Savings Plans allow for a parent, grandparent or other family member to set up a separate plan for each child. An individual may provide up to $13K annually or a couple can fund up to $26K annually for each child's plan, using the annual gift tax exclusion. A unique aspect of the 529 plan is the ability to pre-fund the plan with up to five years' worth of gifts ($130K for a couple or $65K for an individual) when the plan is established.
Growth of investments in a 529 plan is not taxed. As long as the funds are eventually withdrawn for higher education expenses associated with a college or graduate school, the 529 investment and its growth can be withdrawn tax-free.
As an example, assume your daughter is just entering the first grade. Wishing to help pay for their granddaughter's education, your parents put $100K into a 529 savings plan, with their granddaughter named as the beneficiary. Assuming an 8 percent annual return on the 529 plan, when your daughter enters college, the 529 plan will have $252K available for college expenses. If your combined federal and state tax bracket is 35 percent, the tax-free withdrawal of 529 funds could save as much as $53K in income taxes.
529 plans offer great flexibility to the person who funds the plan. In the above example, if the granddaughter decides to go to a public university and does not require the full amount in her 529 plan, the grandparents can change the beneficiary to another grandchild, who can use the remaining 529 funds for their higher education. The grandparents can even provide the remaining funds to grandnieces or grandnephews.
With a 529 plan, you must choose your investments from the investment options offered by the plan administrator. However, the plan owner (funder) can change investment options once every 12 months. If a better plan becomes available, you can even transfer the fund assets to a different plan as often as once per year.
Coverdell Education Saving Accounts - Another way to fund educational expenses is through the Coverdell ESA. Contributions to a Coverdell ESA can be made for any child under the age of 18. The maximum funding per child, regardless of the funding source, is $2,000 per year. Thus, a family with five children can put aside a maximum of $10K per year into Coverdell ESAs.
Similar to the 529 plans, all growth and income in a Coverdell ESA is never taxed, as long as the funds are withdrawn for qualified educational expenses. Unlike the 529 College Savings plan, the Coverdell ESA funds can also be used for K-12 educational expenses. Coverdell ESAs can only be fully funded by individuals with annual income below $95K and couples with income below $190K.
If there are funds remaining in an ESA account, the Coverdell ESA funder may transfer funds from that ESA account into another ESA account as long as both account beneficiaries are under age 30.
If funds are not used for qualified educational expenses Coverdell ESAs and 529 plans have severe tax consequences. In both cases, the income is taxed as ordinary income plus a 10% penalty amount is applied.
However, the flexibility to transfer funds to other family members and their significant tax savings make both plans attractive to any family that is facing the significant costs of higher education.