College Savings Plans: 529 Plan vs. Alternatives

Eric Updated by Eric

College Savings Plans: 529 Plan vs Alternatives

The purpose of this module is to provide a worksheet for evaluating various approaches to saving for a college education. The worksheet allows inputs for the student’s age, number of years of college attendance, annual college costs in today’s dollars, and college cost inflation factor. The module will calculate the projected first year college costs and the projected full-term college costs. Five plans are compared: (1) 529 Plan, UGMA/MTMA, Coverdell, Regular Savings, and U.S. savings bonds. Detailed calculations are performed for each plan and presented as cash flow spreadsheets as well as graphs of plan balances vs college costs and college cost projections. Contributions to the 529 plan and UGMA/MTMA are limited to the annual gift tax exclusion of $19,000 in 2025 per parent; contributions to the Coverdell are limited to the lesser of $2,000 or a high income phase out. Investments in Series EE/I savings bonds are limited to $30,000 per person per year and accumulated interest is taxable upon redemption if subject to high income phase out. A comparison matrix of the various plans lists the plan limits, tax benefits, advantages, disadvantages and impact on financial aid.

With the cost of college growing at an average rate of 5% to 6% per year, college costs will double in 12 to 14 years. If you intend to send your children to college, you will need to pursue an aggressive savings plan. Fortunately, the federal government offers several options for reducing or eliminating taxes on the earnings from savings and investments intended to pay for education expenses. This module provides a worksheet for evaluating five basic methods to save for your child’s college education, each with varying degrees of control and tax advantages, as described below.

CAUTION: The investment rates of return (ROR) entered for each plan must be net of all fees and commissions and should be consistent with the types of investment options available for that particular plan.

(1) Section 529 College Savings Plans -- The tax law provisions for Section 529 College Savings Plans provide significant tax-saving opportunities. The major advantage of Section 529 Plans is that the contribution limit is significantly higher, allowing more dollars to grow tax-free. Each parent (and others) can contribute up to $95,000 (2025) at one time, representing five years of annual gift tax exemptions to front-end fund the plan for maximum benefit. Annual contributions during the next five years cannot be made. Each plan is state-sponsored but you are not required to use your own state’s 529 Plan. However, there may be advantages to do so, especially at the time of withdrawal. There are over 70 different state-sponsored plans and most plans have a wide variety of fixed and age related investments portfolios from which to choose. The investment companies that manage 529 Plans generally invest in their own company’s mutual funds. This is a major drawback of many 529 plans because of your limited control over the individual investment choices. The investment company also charges an administrative fee that can range from about 0.2% to 2.0%. Some plans are sold through brokers with sales commissions as high as 5% of the amount invested. These higher fees can wipe out the tax savings advantage. There is also a 10% penalty tax for non-qualified withdrawals. You should investigate a state’s plan carefully before investing. There may be state income tax benefits (or consequences) with both contributions and withdrawals of 529 funds to be considered. Another factor to consider is the impact of savings on financial aid. Some web sites offering detail information on state plans and financial aid are:

http://www.savingforcollege.com

http://www.collegesavings.org

http://www.finaid.org

Note: The Tax Cuts and Jobs Act of 2017 expanded the allowed use of Section 529 Plans to cover up to $10,000 per year (per beneficiary) of primary and secondary education expenses.

(2) UTMA/UGMA (Universal Transfers/Gifts to Minors Act) Accounts -- With this option, you transfer assets into a custodial account for the benefit of a child under the control of a trustee (normally the parent). This transfer is an irrevocable gift to the minor and although the funds may be intended for college, upon reaching the age of majority, the beneficiary can “legally” use the funds for any purpose. In addition to retaining total control over the investments, earnings in the account are taxed at the child’s rate, except for the “kiddie tax” which is a tax (at the parent's rates) on annual earnings over $2,700 (2025) until the child reaches the age of 19 (24 if full time student). At age 19 (24 if full time student) and over, all earnings are taxed at the child’s rate. Most strategies limit investments so that earnings remain below the taxable threshold. Note: The module only approximates the tax calculation for this option by assuming an average 5% tax rate.

(3) Coverdell Education Savings Account (ESA, formerly Education IRA) -- The Coverdell Education Savings Account is also a custodial trust account (and an irrevocable gift); however, it is set up specifically for the education expenses of the beneficiary under the control of the trustee (normally the parent). This means the child does not have the right to withdraw funds at the age of 18 for a new car or trip to Tahiti. Also significantly, all earnings are tax-free when withdrawn for qualified education expenses and you still retain total control over the investment choices. Qualified expenses for ESAs include elementary and secondary school (K-12, public or private) expenses as well as college expenses. A major drawback to this approach is the maximum allowable annual contribution for each child from all sources is only $2000. Also, if funds are withdrawn for other-than-education expenses, there is a 10% tax penalty in addition to the regular income tax due. Note: The Tax Cuts and Jobs Act of 2017 expanded the allowed use of Section 529 Plans to cover primary and secondary education expenses. This change leaves little reason to choose the Coverdell ESA over a 529 plan.

(4) Regular Savings Account -- The basic approach is simply to retain total control of the funds intended for college and pay taxes on the investment earnings at the parent’s (higher) rate. Long-term capital gains will be taxed at the more favorable long-term capital gain rate when investments are sold. One advantage of this approach, besides retaining total control, is that the funds remain assets of the parents, not the child, and will be treated more advantageously in financial aid calculations.

(5) U.S. Savings Bonds – This option is a variation on the regular savings account using U.S. series EE bonds issued after 1989 and all series I bonds as the investment vehicle. For married taxpayers with adjusted gross income $179,250 or less ($114,500 for single filers) (2025), some or all the interest earned is tax-free if used for higher education. One advantage of this approach, besides safety and retaining total control, is that the funds remain assets of the parents, not the child, and will be treated more advantageously in financial aid calculations. The disadvantage is the low returns. See www.treasurydirect.gov for current bond rates.

Tax Credits -- The Lifetime Learning Credit and American Opportunity Tax Credit reduce taxes for qualified education expenses. The Lifetime Learning Credit is phased out for AGI between $160,000 to $180,000 (MFJ) and $80,000 to $90,000 (SGL). The Lifetime Learning Credit is available to all students enrolled in eligible educational institutions including graduate students and workers returning to school to upgrade their skills. The credit is equal to 20% of the first $10,000 in expenses for a maximum of $2,000 per family.

The American Opportunity Tax Credit can reduce taxes by $2,500 a year (100% of the first $2,000 and 25% of the next $2,000) per student for the first four years of undergraduate school when pursuing a degree. The credit is phased out for AGI between $160,000 to $180,000 (MFJ) and $80,000 to $90,000 (SGL).

Financial Aid Considerations -- When colleges determine financial aid packages, they calculate the amount the family is expected to contribute to the child’s education (EFC). The child’s assets including UTMA and Coverdell accounts count for up to 35% while parent’s assets including 529 Plans count for up to 5.64%. The child’s assets therefore, should be spent first in order to reduce the amount of the family’s expected contribution. Although savings affect the amount of financial aid for which a student is eligible, the financial aid will generally be in the form of student loans, as only students with very low EFCs are eligible for grants.

Strategies -- Although you may intend to fund 75% to 100% of college expenses, you should plan on saving no more than 75% to 80% of your intended contribution in tax-favored education savings accounts in order to ensure you can receive the maximum benefits penalty-free from these accounts. College savings plans should be carefully integrated with retirement savings plans. Determining the amount to save for your children’s college education and the amount to save towards retirement is an important and often difficult decision. Careful planning is needed to help ensure that your college savings plan is consistent with your retirement goals. Some 529 plans offer very low-cost index-based mutual funds and a few others offer individual fund selection which can make a well-researched 529 plan a highly valuable tool for your college savings. Selecting the best plans and investments can make a significant difference of many thousands of dollars in the amount of money that will be available when college bills arrive.

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