Even for affluent clients, the tab for a child’s college education is a tough nut to crack. According to recent statistics from Lending Tree, the average total annual cost of attending a public college is $25,290 for in-state students and $40,940 for out-of-state students. And the average cost for a private school is a staggering $50,900!
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The best thing your clients can do is to plan ahead for the day of reckoning. Fortunately, there are several tax-advantaged ways to build up funds for college, with the stamp of approval from the IRS. Consider these four options:
1. Section 529 Plans: By far, this is now the most popular way for parents to save for college. (Grandparents may chip in, too.) With a 529 plan operated by the applicable state, you can set aside funds for a child’s future education. The amounts contributed to the plan continue to compound on a tax-deferred basis. What’s more, the contribution limits set by the state reach as high as $300,000, so there’s plenty of leeway.
When distributions are made for qualified expenses like tuition and fees, the payouts are exempt from tax. Plus, if you have any amount left over in the account when your oldest child graduates, you can roll over the funds for a younger child. Note: Under the Tax Cuts and Jobs Act (TCJA), a 529 plan may also be used to pay for up to $10,000 of annual expenses at a private elementary or secondary school.
2. Custodial Accounts: This is one of the old-fashioned ways of saving for college. Essentially, you set up a custodial account according to your state’s Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). The custodian manages the funds for the child’s benefit until he or she can legally access the money. Due to the widespread appeal of Section 529 plans, custodial accounts aren’t as prevalent as they were in the not-so-distant past, but they’re still kicking around.
Caveat: Beware of the “kiddie tax.” Generally, investment income exceeding an annual threshold ($2,200 for 2019) that received by a dependent child under age 24 is taxed tax rates in effect for estates and trusts. (Prior to the TCJA, the excess was taxed at the parents’ top tax rate.) This usually results in a higher tax than would otherwise be owed.
3. 2503(c) Trusts: This type of trust, also called a “minor’s trust,” is designed to provide funds for beneficiaries that may be used to pay for college. As with custodial accounts, 2503(c) trusts have around for years, but have waned in popularity when compared to 529 plans.
With a 2503(c) trust, the income is taxed directly to the trust. Because the trust tax brackets are relative narrow, parents may be inclined to skip this option at higher income levels.
4. CESAs: A Coverdell Education Savings Accounts (CESA) is like an IRA that’s used for education instead of retirement. (In fact, it was initially dubbed the “Education IRA.”) Payouts for qualified expenses are exempt from tax. But the annual contribution limit is a mere $2,000 and hasn’t budged in years. Thus, this option pales next to 529 plans.
Despite this drawback, amounts in a CESA can be rolled over tax-free for multiple beneficiaries. A CESA may also be used for private elementary and secondary schools without any limit on expenses.
In summary: Of course, when their child finally enters college, your client may be eligible for certain tax breaks, such as credits for higher education. But the tax advantages are generally scaled back or eliminated for upper-income taxpayers. At least clients can benefit from tax-favored accounts in the meantime. Encourage them to discuss the alternatives with you and develop a savings plan that meets their needs.