September 1, 2021
Attending college in America is expensive. For the 2020-2021 academic year, the average cost of tuition and fees alone was between $10,560 (public in-state) and $37,650 (private). With room and board, the annual cost increases to over $20,000 per student, making the average total price for a four-year degree between $88,720 and $203,080. Families concerned about the rising cost of education should take advantage of tax-smart college savings strategies.
Coverdell Education Savings Account
A Coverdell education savings account (Coverdell ESA) is a trust or custodial account that pays solely for the designated account beneficiary’s qualified education expenses. The allowable contribution of $2,000 per year to each child’s Coverdell ESA account is not tax deductible, but earnings are tax-free. Withdrawals are also tax free if used for the account beneficiary’s post- secondary tuition, fees, books, supplies, and room and board. This benefit also applies to qualified elementary and secondary education expenses.
Before setting up a Coverdell ESA, carefully consider the various rules and restrictions. Your eligibility for Coverdell ESA contribution phases out between modified adjusted gross income (MAGI) of $95,000 and $110,000 for a single taxpayer, or between $190,000 and $220,000 for a married joint filer (for tax year 2020, amounts adjusted annually). Contributions for the current tax year must be made by April 15 of the following year. In addition, contributions cannot be made after the beneficiary turns 18, and all money in Coverdell ESA must be withdrawn within 30 days of when the beneficiary student turns 30. Taxpayers who contribute to a Coverdell ESA receive a tax form 5498-ESA, and they should use a tax form 1099-Q to report distributions from a Coverdell ESA.
Coverdell ESAs are not as widely used as Section 529 plans due to various restrictions as briefly described above. Providers are limited for this reason. You can view a helpful list of providers assembled by Saving For College. Please note, we do not endorse any of the providers and this website link is provided for your information only. Please consult with each financial institution for accuracy.
Section 529 College Savings Account
Section 529 college savings plans are state-sponsored arrangements with valuable tax benefits similar to Coverdell ESAs. Once a 529 plan is set up, you can make contributions to a trust fund set up by the state 529 plan of your choice for a designated beneficiary.
Contributions can be made lump-sum or by installment or periodic payments over several years. There is no federal annual contribution limit as with Coverdell ESAs, but state tax deductions, if available, are usually capped at a dollar amount set by the state.
The main tax advantage of 529 college savings plans is that the earnings grow tax free, and withdrawals are also tax-free when they are used to pay qualified education expenses for the beneficiary. There is usually no state income tax on such withdrawals when both the contributor and the account beneficiary reside in the state sponsoring the plan. State income tax deductions or credits may be available for contributions to the state of your residency. If the account owner or beneficiaries are nonresidents of the state that sponsors the plan, more careful review is needed to examine potential state income tax consequences.
There is no specific tax form for Section 529 contributions, but a tax form 1099-Q is issued in the year when a taxpayer withdraws from a 529 account. It is important to keep records to substantiate qualified education expenses paid for with 529 withdrawals.
New Laws Expanded Use of 529 Funds – K-12 tuition and Student Loan Payments
The Tax Cuts and Jobs Act (enacted in 2017) expanded the approved use of 529 savings plans to include certain public, private or religious K-12 tuition expenses. Withdrawals of up to $10,000 per beneficiary per year for K-12 tuition may be taken as a qualified expense from a 529 plan. However, the costs of textbooks, room and board, supplies and other expenses for K-12 education are not covered, and homeschooling expenses are currently not considered qualified higher education expenses.
Additionally, the SECURE Act (enacted in late 2019) further expanded the definition of qualified education expenses to include student loan payments and registered apprenticeship programs. The law includes an aggregate lifetime limit of $10,000 in qualified student loan repayments per 529 plan beneficiary.
Some states have not conformed with the federal law and consider K-12 tuition a non-qualified 529 plan expense. Families in non-conforming states who use 529 plan funds to pay for K-12 tuition may be subject to state income tax on the earnings portion of the non-qualified distribution, and state income tax benefits may be subject to recapture.
529 and Estate Planning Advantages
Most 529 college savings plans permit lump-sum contributions of a large dollar amount (well over $300,000). This allows an estate planning opportunity for a taxpayer who wishes to make a gift and reduce his or her taxable estate. For federal gift tax purposes, contributions up to $15,000 (for 2020 and 2021, per taxpayer) may be made without tax or a gift tax filing requirement – this is known as a gift tax exclusion. Also, a taxpayer may elect to spread a large lump-sum contribution over five years and immediately benefit from five years’ worth of annual gift tax exclusions.
For example, a grandmother may make a lump-sum contribution up to $75,000 ($15,000 * 5) to her grandson’s 529 account as a single taxpayer without any federal gift tax consequences. Gifts up to these amounts will not reduce the contributing taxpayer’s unified federal gift and estate tax exemption ($11.70 million for 2021; $11.58 million for 2020).
Section 529 Prepaid Tuition Plan
Like Section 529 College Savings accounts, Section 529 Prepaid Tuition plans offer favorable federal tax treatment for contributions and withdrawals (i.e. earnings grow tax-free, and withdrawals are tax free if paid for qualified education expenses).
Section 529 Prepaid Tuition plans lock in the cost to attend certain colleges. This means the rate of return on a prepaid tuition plan will be matched the inflation rate for costs to attend the designated school(s) as allowed by the plan. Because the school choices are very limited on the 529 prepaid tuition plans, these plans should be considered when the beneficiary is certain on the school s/he would like to attend.
Saving with a “Regular” Taxable Investment Account
While saving with a standard taxable investment account may not be specifically designed to provide education tax benefits, it may be a good option if you wish to save more for your child, spouse, or other dependent’s higher education expenses.
For 2020, the maximum federal income tax rate on net long-term capital gains and qualified dividends is 20 percent (for a single taxpayer with taxable income of more than $445,850; for a married joint filer with taxable income of more than $501,600 for 2021), but most taxpayers will pay no more than 15 percent.
The effective federal income tax rate on long term capital gains or qualified dividends can increase to the maximum of 23.8% if net investment income tax applies (usually for taxpayers with modified adjusted gross income over thresholds, $250,000 for married joint filers or $200,000 for single). Even with this, taxpayers would more likely pay less tax on long term capital gains and qualified dividends. If held for more than one year, college savings through a standard brokerage account will provide more flexibility for how the money can be used as well as additional options for where the money can be used by dependents in the future.
While capital gains are not typically a deterrent, there could be gift tax consequences (if the account owner is you and you give more than the annual gift exclusion). Also, placing this type of taxable investment account in the name of a minor child’s could trigger “kiddie tax.”
Smart College Planning
When it comes to saving for a college education, the key is starting early. Taxpayers should do their homework on the advantages of various savings programs and talk to a tax advisor about the best tax strategy. For more information about tax-smart college saving, contact Jennifer Galstad-Lee at firstname.lastname@example.org. Read additional articles from our 2021 Year-End Tax Planning Series for more tax planning strategies and helpful tips.
Jennifer Galstad-Lee, CPA, JD
GRF CPAs & Advisors