Understanding your options for educational funding

The cost of tuition in the United States has increased dramatically over the last decade. Between 2008 and 2018 alone, the average tuition at a four-year public college increased by 37%.1

Due to this considerable cost surge, it’s important for parents and students to consider available options to help finance higher education. Explore the lesson below to learn more about ways to help pay for higher education — including 529 plans, Coverdell accounts, and custodial accounts.

529 plans

What is a 529 plan?

A 529 plan is a tax-advantaged education savings plan designed to help families set aside funds for future college costs. It’s named after Section 529 of the Internal Revenue Code.

Every 529 plan requires a named custodian — typically a parent or grandparent — who will own the account, make investment decisions, and decide on the distribution of assets. The account owner maintains ownership of the account until the money is withdrawn. Each plan also requires one designated beneficiary. This is usually the student or future student who will receive benefits from the plan.

Advantages and restrictions

Any earnings generated in a 529 plan grow free from federal income taxes and may be eligible for state tax deductions, as long as withdrawals are used for qualified higher education expenses. Any earnings withdrawn that are not used for such expenses are subject to federal income tax and may be subject to a 10% additional tax, as well as applicable state and local income taxes.

Section 529 plans are established by individual states, but they’re offered to residents of all states. However, laws of the owner’s home state may allow favorable tax treatment only for investments made in the home state’s 529 plan. You can also open a 529 directly with an independent financial services provider.

You may change the designated beneficiary of a 529 plan to a different member of the family without incurring tax consequences. Also, you may transfer funds from a 529 plan without penalty if you roll them into another plan for the same beneficiary or for a member of the beneficiary’s family. So, for example, you can roll funds tax-free from one child’s 529 into a sibling’s plan.

Plan administration

College savings plans are usually managed by financial services firms, and may differ significantly in features and benefits. Plan assets are professionally managed either by the state treasurer’s office or by an outside investment company that serves as the program manager.

Contribution limits

No age or income restrictions apply for contributions or beneficiaries.

As of 2020, gifts totaling up to $15,000 can be contributed each year without gift-tax consequences.

A contribution of $15,000 a year or less qualifies for the annual federal gift tax exclusion. And, under special rules unique to 529 plans, you can gift a lump sum of up to $75,000 ($150,000 for joint gifts) without incurring a federal gift tax, as long as you spread the gift evenly over five years.

Impact on financial aid

Whenever possible, designate a parent or guardian as the account owner of a 529 plan; otherwise, it can impact a student’s financial aid eligibility.

Coverdell Education Savings Accounts (Coverdell ESA)

What is a Coverdell ESA?

Like a 529 plan, a Coverdell account offers tax deferred investment growth and tax-free withdrawals to finance the beneficiary’s qualified education expenses.

Advantages and restrictions

These accounts function similarly to 529 plans in many ways. However, the money saved in a Coverdell ESA may be applied to certain qualified elementary and secondary education expenses, in addition to higher education.

Contribution limits

The annual contribution limit per designated beneficiary in a Coverdell account is $2,000.

Custodial accounts

What is a custodial account?

Custodial accounts can be set up through both the Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors (UTMA). These accounts allow parents or guardians to make gifts of cash or securities to minors.

Advantages and restrictions

Custodial accounts may offer tax advantages, investment options, and flexibility, since the money can be used for more than just education. However, there are certain restrictions to carefully consider before establishing and using these accounts. Keep in mind, the income in your child’s custodial account belongs to the child, so he or she may have to file a separate federal income tax return for this income.

Additionally, the “Kiddie Tax” may cause the funds in your child’s custodial accounts to be taxed at a higher rate.

There are several approaches you may want to consider when it comes to funding your child’s education. Make sure to review the advantages and restrictions associated with each method, and carefully consider your options before taking action.

You may want to consult with a financial professional to learn more and discuss your family’s needs.