Planning for college is daunting. There are several things that parents and students need to consider, and it can be hard to keep track of every detail, ensuring that every box is checked. One of the first, most important decisions you need to make as a family is how are we going to save for the cost of college? Deciding how you’re going to save for college starts with the decision of which account type you will use? There are numerous options for college saving, and each one has different taxability and investment options that will need to be considered.
It’s important to consider various criteria when deciding on the type of account you will use for college savings. These criteria include:
There are many account types that provide numerous college savings tax incentives. This is an important consideration because these benefits will allow any money that is not spent on taxes to go directly towards college affordability.
There are numerous investment possibilities. While some alternatives have a very narrow range of what they may give, others offer considerable freedom. While some alternatives offer flexible operations, others only offer a few options. They restrict what can be done with the accounts, where they can be, where the money goes, who can use the money, and other things.
Any savings, whether college or general, can be held against you in the consideration of your financial aid. Each type of account will have a different impact on your ability to eventually obtain financial aid.
The 529 Plan is among the most well-known varieties of college savings accounts since it offers numerous tax advantages for higher education, encouraging people to start saving for college in exchange for these advantages. The 529 Plan's tax-free growth is one of its main benefits. Both investment growth and any income put into the plan are tax-free. Any withdrawals are likewise tax-free as long as the funds are used for eligible educational costs like college tuition. In many jurisdictions, you might even get a tax break merely for contributing any amount to a 529 Plan. The 529 Plan's high contribution cap and ability to circumvent gift tax laws are further advantages. That means there are no tax repercussions for parents who donate up to $15,000 per to their child's 529 Plan account for college expenses. Despite the fact that the 529 Plan has some restrictions, it is still a very advantageous savings account. The fact that the plans are typically state-sponsored is one of these restrictions. This means that there are limited investment options.
The state will provide you with a variety of investment options, similar to a 401(k) or pension plan, but you won't have the freedom to select the investment option you want. The fact that your money must be spent for educational expenditures is another restriction placed on the 529 Plan.
The restrictions have recently been altered to permit the use of funds for K–12 school costs. All money must, however, be used for legitimate educational costs like tuition. You risk a 10% penalty and taxation on the money if the funds are not used for the proper school costs. The option to donate the account to someone else or transfer it to another family member is available in the case that the intended child does not end up requiring the money for college.
The Coverdale Educational Savings Account is referred to as a Coverdale ESA. Similar to the 529 Plan, the tax advantages allow your contributions to remain tax-free as long as they are in the account or are withdrawn for any K–12 or higher education educational objectives. The Coverdale ESA has a restriction that there can only be a $2,000 annual contribution to the account.
However, because the funds are invested through a brokerage firm rather than a state-sponsored program, there is greater flexibility in how they can be used. Another restriction with a Coverdale ESA is that the funds have to be taken out before the child turns 30.
Custodial accounts are also referred to as Universal Gift to Minors or Universal Transfer to Minors accounts. On these accounts, the parents are listed as the custodians along with the child's name, and they have the authority to make investment decisions until the youngster turns 18, 21, or 25.
When it comes to financial aid, the money invested in these accounts is treated as an irrevocable gift to the child. The Coverdale ESA and the 529 Plan are both considered parental assets and so eligible for financial help, however UGMA/UTMA accounts are considered the child's assets and are not. Custodial accounts offer an unlimited number of investment alternatives and can be opened at any conventional institution. You can save a lot of money with a custodial account because to the investment options' flexibility and the absence of contribution caps.
The disadvantage of UGMA/UTMA is that there are no tax incentives because they are not tax-efficient. The money put into the child's account will be taxed at the child's rate, which is marginally less than the parent's rate, with ever-evolving thresholds. Receiving $2,200 in unearned income at the child's tax rate is the only tax benefit associated with a custodial account, which is not much of a benefit. Contrary to 529 or Cloverdale accounts, you are not subject to tax penalties if you withdraw money for non-educational costs. Because of this, you have a lot more flexibility in how you can spend the account's money.
A Taxable Brokerage account works like any actual savings or investment account. It is similar to a regular wealth accumulation account and provides the most flexibility. There are no contribution limits with these accounts, and you can invest in anything that you choose, including stocks, bonds, and mutual funds. Whoever owns the brokerage account will have a significant impact on the student’s financial aid. If the account is in the parent’s name, it will be counted as the parent’s asset, which is good for financial aid. If the account is in the child’s name, the assets will be considered the child’s.
There is also the option of splitting the account into the child and parent’s names, which makes the assets 50% parent and 50% child, and will split financial aid consideration. Keeping the account in the parent’s name reduces the impact on financial aid and provides more flexibility. While there are many positives to a Taxable Brokerage account, there is the downside of missing out on tax incentives. Just as with any other regular investment account, you will have capital gains and income tax rates.
An account with a tax incentive is a Roth Individual Retirement Account (Roth IRA). Money that has already been taxed is put into a Roth IRA. You never pay taxes again on the money, and it grows tax-free. Any funds withdrawn from a standard IRA before to the age of 59 and a half are subject to taxes and a 10% penalty. However, the IRS permits withdrawals from IRAs for education expenses. The IRA is adaptable and, in terms of investing, is comparable to a Taxable Brokerage account. Because a Roth IRA is ultimately a retirement account, it has limitations on the amount you can contribute each year. Due to the limited contributions, if you take a sizable deduction to pay for college, it will reduce the amount you would eventually receive in retirement. Because of this, a Roth IRA is an excellent backup plan but shouldn't be the main method of paying for college.
You should consider the advantages and disadvantages of each of these major college savings account types before choosing the one that best suits your needs. Remember that you are not required to select just one kind of account.
You can employ a combination to take advantage of the various incentives and advantages of a few various account kinds. For instance, you might decide to put 50% of your money in a 529 Plan and the other 50% in a Taxable Brokerage account if you're searching for tax benefits and flexibility. You are allowed to have as many accounts as you like.
Considering your family's requirements and resources, choose the best course of action to preserve your child's prospective college future. When comparing your various college finance alternatives, there are several factors to take into account. To determine which options are best for you and your family, it is crucial to speak with a financial counselor or tax expert.
Speak with Josh today to find out which would be best suited to you!