Tax-Smart Strategies to Help Your Kids Pay for College

In the Face of Skyrocketing Education Costs, it Pays to Prepare

Even if they’re still quite young, it’s never too soon to begin planning strategies to help your kids pay for college in the future. Higher education is already expensive, and because college costs increase at about two times the rate of inflation each year, it will only get pricier as the years go by. Currently, it’s estimated that today’s toddlers – who will start college around 2038 – can expect to spend around $35,592.339 each year on tuition, fees, room, and board for an in-state public school. For kids who want to go to a private school, they can expect to spend around $81,470.95 yearly for the same.

Luckily, there are many financial aid opportunities, scholarships, and grants that can help your child cover college costs. In addition to these, there are also some key financial planning strategies that can make college costs a bit more manageable.

529 Plans

One of the more popular and tax-savvy ways to save money for college is a 529 plan. A 529 plan is an investment plan that offers tax benefits when the funds are used to pay for qualified education expenses for a designated beneficiary. Though the funds put into the account are taxed, the money grows tax-deferred, and distributions used for qualified expenses come out federally tax-free. Since any contributions made to a 529 plan are considered gifts, the annual contribution amount matches the annual gift exclusion amount. An annual exclusion is the amount of money that one person may transfer to another as a gift without incurring gift tax. For 2022, you can gift up to $16,000 per beneficiary.

While contributions are strictly regulated by the gift tax parameters, there are ways to get around this. Those who are wealthy enough can “superfund” a 529 plan by contributing five years of gifts at one time, per person, without incurring the gift tax fee. What this means is that parents (or grandparents) with the ability to do so could contribute $75,000 each ($150,000 combined) when a child is young, then allow that money for many years to grow so that they have a substantial account balance to rely on once they reach college age. The rules for making this happen can be complicated, so it’s best to be sure that you have an advisor or professional you trust.

There are two types of 529 plans:

College Savings Plans

Similar to a 401k or IRA, contributions made to a college savings plan are invested in mutual funds or other investment products. So, any money the account earns is based on the market performance of those underlying investments. Because of this, most of these plans offer age-appropriate investment options that slowly begin minimizing risk as the beneficiary nears college age. There is a catch, though, in that these plans can only be administered at the state level.

Prepaid Tuition Plans

A prepaid tuition plan allows for donors to lock in today’s tuition rate by pre-purchasing all or part of a student’s college tuition. The great thing about these plans is that the amount paid is guaranteed to grow at the same rate as college tuition, meaning your contribution will match the tuition costs when it comes time for the beneficiary to begin college. Only a limited number of states offer this kind of plan, and they are typically only used for students who plan to go to an in-state college or university and only need help to cover the cost of tuition.

Traditional and Roth IRAs

An IRA is a tax-advantaged saving account where you keep investments such as bonds, stocks, and mutual funds. While these accounts are typically only thought of as retirement savings vehicles, they can be used to help with educational costs, as well. IRAs have become even more ideal for college savings under the SECURE Act, which removed the age requirement for depositing money, so you can continue making contributions at any age as long as you’re still working.

Generally, if you withdraw from your IRA before you’re 59 ½ years old, you’re hit with a 10% additional tax penalty. However, you are allowed to withdraw money early to pay for qualified higher education expenses for yourself, a spouse, your children, or your grandchildren without incurring the 10% penalty. It’s important to note that, though you won’t be penalized, you will still owe income tax on the distribution unless it’s coming from a Roth IRA (which, by its nature, is funded with after-tax dollars).

Though this is a viable option, using your retirement funds to pay for your child’s college tuition may not always be the smartest option. Before taking money out of your retirement savings – money that you can’t put back in once retired – you’ll want to be sure that you are well-funded for retirement outside of the IRA you’re using. Additionally, don’t forget that any distributions you take out will be considered income on the following year’s financial aid application, so it could affect eligibility for need-based financial aid that your child would have otherwise qualified for.

If you don’t want to dip into your retirement savings, and your child is working, you may want to consider opening up a Roth IRA in their name. So long as your child is earning money during the year any contribution is made, you can fund their annual contributions – just make sure it’s in line with your child’s earnings. Meaning, if your child earns $1,000 from a summer job, then you can make the $1,000 contribution to their Roth IRA with your own money, allowing them to use the money they earned for other financial responsibilities.

Coverdells

A Coverdell Education Savings Account (ESA) works a lot like a 529 plan. It allows money to grow tax-deferred within the account, and all withdrawals that are used for qualifying education expenses can be taken out tax-free at the federal level (and, in most cases, the state level, too). Qualified education expenses don’t only apply to college or university costs, but to elementary and secondary education expenses, as well. If any money withdrawn is used for an unqualified expense, you’ll not only have to pay taxes on your withdrawal but you’ll also be penalized 10% on earnings.

Contributions made to a Coverdell ESA are not deductible and can only be made before the beneficiary turns 18. What’s more, though a beneficiary can have more than one Coverdell ESA set up for them, there is a maximum contribution limit of $2,000 per year, per beneficiary – not per account. Additionally, if you’re looking to contribute to a Coverdell ESA, your modified adjusted gross income (MAGI) must be less than $110,000 if you file solo, or $220,000 if you’re a married couple filing jointly.

Custodial Accounts

Custodial Accounts, such as those created through the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA), allow you to put money and/or assets into a trust for a minor. As the trustee, you’ll have full rights to manage the account until the beneficiary turns 18. After that point, they’ll own the account and be able to use the funds however they wish – the money doesn’t have to be used for education.

Technically, these types of accounts have no contribution limits. However, if you don’t want to trigger the gift tax, then you’ll want to keep your contributions under $16,000 per individual. One crucial thing to keep in mind with these accounts is that the money is considered to be the students’ assets rather than your own, which can impact your child’s eligibility for financial aid.

Cash

So long as you don’t breach the annual exclusion limit of $16,000 per person, you can gift your child cash each year to help them foot the financial burdens associated with college. Gifts that exceed the annual exclusion count against the lifetime exemption, which is currently $12.06 million.

Final Thoughts on Tax-Smart Strategies to Help Your Kids Pay for College

Inflating college costs are showing no sign of slowing down, but you do have options. Begin planning for your children’s college funds as soon as you decide that’s something you want to assist with. Any of the plans and programs listed above can help you prepare for the cost of college while also supporting savvy tax planning.

If you’d like to talk with one of our professional financial advisors about how you can put a plan in place for your child’s education costs – without neglecting your retirement plans – contact us today.

Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”).  This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.


Zachary Morris, CFP®

Having traveled to over 35 countries, Zach is a believer in Ralph Waldo Emerson’s statement that Life is about the journey, not the destination. Being a CERTIFIED FINANCIAL PLANNER™ provides Zach the opportunity to help clients define and realize their journey, and co-founding Paces Ferry Wealth Advisors, an independent firm, allows the freedom to define the client experience along the way.

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