Section 529 plans provide a valuable tax-advantaged savings opportunity. You can choose a prepaid tuition plan to secure current tuition rates or a tax-advantaged savings plan to fund college expenses beyond just tuition. Some states offer both types of plans, while other states only administer one type of plan or the other. Here are some of the possible benefits of such plans:
· Although contributions are not deductible for federal purposes, any growth is tax-deferred. Some states do offer tax breaks for contributing.
· Plans usually offer high contribution limits but there are no income limits for contributing.
· Generally there is no beneficiary age limit for contributions or distributions.
· You, the donor, can control the account, even after the child is of legal age.
· You can make tax-free rollovers to another qualifying family member’s 529 plan.
· A special break for 529 plans allows you to front-load five years’ worth of annual gift tax exclusions and make up to a $75,000 contribution (or $150,000 if you split the gift with your spouse) in 2018.
Prepaid tuition vs. savings plan
Understanding the difference between the two plans is critical for making your decision.
With a 529 prepaid tuition plan, if your contract is for four years of tuition, tuition is guaranteed regardless of its cost at the time the beneficiary actually attends the school. One downside is that there’s uncertainty in how benefits will be applied if the beneficiary attends a different school. Another negative is that the plan typically doesn’t cover costs other than tuition, such as room and board.
A 529 college savings plan, on the other hand, can be used to pay a student’s expenses at most postsecondary educational institutions. Distributions used to pay qualified postsecondary school expenses (such as tuition, mandatory fees, books, supplies, computer equipment, software, Internet service and, generally, room and board) are income-tax-free for federal purposes and typically for state purposes as well, thus making the tax deferral a permanent savings.
TCJA has permanently expanded qualified expenses to include elementary and secondary school tuition. But tax-free distributions for such expenses are limited to $10,000 annually per student. The biggest downside may be that you don’t have direct control over investment decisions; you’re limited to the options the plan offers. Additionally, for funds already in the plan, you can make changes to your investment options only twice during the year or when you change beneficiaries. For these reasons, some taxpayers prefer Coverdell ESAs.
Education Savings Accounts
Coverdell Education Savings Accounts (ESAs) are like 529 savings plans in that contributions are not deductible for federal purposes, but plan assets can grow tax-deferred and distributions used to pay qualified education expenses are income-tax-free.
One of the biggest ESA advantages used to be that they allowed tax-free distributions for elementary and secondary school costs and 529 plans did not. With the TCJA enhancements to 529 plans this is less of an advantage. However, tax free withdrawals from 529 plans are limited to K–12 tuition, while Coverdell ESAs can be used to pay for elementary and secondary qualified education expenses other than tuition and there is no dollar limit on such annual distributions.
Another advantage is that you have more investment options. ESAs are worth considering if you want to fund elementary or secondary education expenses in excess of $10,000 per year or beyond just tuition or would like to have direct control over how and where your contributions are invested. However, the $2,000 contribution limit per year for each beneficiary, and only until they turn 18, is low and is phased out based on income. The limit begins its phase out at a modified adjusted gross income (MAGI) of $190,000 for married couples filing jointly and $95,000 for other filers. No contribution can be made when MAGI hits $220,000 and $110,000, respectively.
Amounts left in an ESA when the beneficiary turns age 30 generally must be distributed within 30 days and any earnings may be subject to tax and a 10% penalty.