by Trent Krassow, ARe, ARM, CMA, EA, MBA
We keep hearing about the cost of college, the student loan crisis in the country, and the inability of the average family to keep up with the inflation in the cost of education. And all of this has at least some reality. But throwing up our hands and giving up is NOT a solution! So what is a caring parent to do?
First, I think it bears stating that almost nothing in our world continues in a linear fashion. Educational trends change, the means of delivery of education changes, and certainly, the savings and tax planning vehicles change. The delivery of education was already changing before the world of COVID, and I think we will continue to see disruptions in this space for many years to come.
Secondly, while saving early and often is a key component of planning for funding education, most families should plan on combining several strategies to make sure educational goals are met. These include tax-advantaged savings plans, tax credits, scholarships, picking an affordable college, and good old fashioned hard work. While this article will specifically focus on the current savings plans available, don’t forget to look broadly for your funding strategies!
There are many ways to save for college:
old fashioned savings accounts,
purposeful investing (stocks, mutual funds, real estate, etc.),
IRA’s,
prepaid tuition,
Coverdell Educational Savings Accounts (ESA for short), and
Qualified Tuition Plans (QTPs), also known as 529 plans.
Let’s focus on those last two for now.
First, what are ESA’s and 529’s? Both are tax-advantaged ways to save for college. Think of them both as an “educational Roth IRA” – you put money in, and as long as the money is used for qualified educational expenses, you don’t pay tax on the money when you pull it out. That’s the simple explanation.
Now, a bit more detail: with both plans, the tax benefit is in the future, at least on the Federal level – different states have different treatment of this – for example, Colorado, allows a current year deduction for contributions to a Colorado 529, even though the same contribution does not impact your Federal taxes this year.
So where is the benefit? The benefit is that as that money grows, it is not taxed along the way, and if properly used, it is not taxed when taken out, either. This has the biggest benefit where you have more time for compounding interest.
Some examples may help, here. Suppose two families in the same state have babies on the same day. Family A immediately opens up a 529 for the new arrival and contributes $10,000 on the day of birth. The other family, Family B, is just as happy to have their little bundle of joy but decides it will contribute to a 529 for Junior at a later date, and waits until the child is 17 years old, contributing $10,000. Meanwhile, Family A has not continued to contribute, but only contributed the initial $10,000 at birth. Thus, both families have contributed the exact same amount to a 529 for their children. Let’s assume a 7% average rate of return (which means some years it was more, some less), just for illustration. Here is how the two families fare on the 18th birthday of these unrelated “twins:”
Family A Family B
Contributed $10,000 $10,000
Years of Growth 18 1
Rate of Return 7% 7%
Final Amount $33,799 $10,700
Growth Amount $23,799 $700
Timing is everything! Family A had 18 years for compounding interest to work it’s magic, whereas Family B only had 1, so the same dollar amount contributed had much more impact for Family A!
As both families send their children off to college, they both appropriately use all of the funds for approved educational expenses, so neither pays tax on the amounts withdrawn from their 529 plans. Which family got the biggest tax benefit? Family A, of course. The longer the time horizon, the bigger the benefit of tax-free growth.
The same principle applies to a Roth IRA, as well as the ESA – all of these savings vehicles have this in common: you pay tax on the contributions as you go, but not on the growth down the road if used at the appropriate time and for “approved” purposes.
So which college savings plan should I use, the 529 or the ESA, since they appear to be the same thing?
Well, in many cases the answer is Yes! Many families qualify to contribute to both. In the “old days” (as in, 10 years ago), the ESA was thought to have greater flexibility in terms of investment options, so for those that qualified (there are income limitations for the ESA), this was the preferred choice. This is still generally the case (you can pretty much choose almost any stock, bond, or mutual fund that your account provider offers), but many 529 plans have greatly improved the investment options in recent years, so it is important to look at the options available to you. It is still true, nonetheless, that 529’s are more restrictive, as they come with a set, limited menu. Some 529 plans even have a prescribed investment based on the age of the beneficiary. These plans are designed to limit risk but can have the unintended effect of limiting returns, and in some cases, creating losses at just the wrong time – the fine print matters, here. Have your investment professional, accountant, or advisor dig in with you if need some guidance.
529’s and ESA share other characteristics, as well. Both can be transferred to another member of the family, which is a nice feature, since the money may not be needed for the original intended beneficiary, and may be needed more for a sibling. For example, maybe Susie gets a full-ride scholarship and doesn’t need any of the money Mom and Dad saved up over the last 18 years, but her brother Johnny has a funding gap for his college expenses. Susie’s ESA or 529 funds can be transferred to Johnny. Of course, if either Susie or Johnny decides to use 529 or ESA funds for that new car, the dreaded 10% penalty plus the tax rate will apply (which makes using the money for non-approved purposes REALLY expensive – don’t do it!).
But there are some key differences, too. While the ESA generally offers more flexible investment options, it also has more restrictions than a 529 plan. For example, ESA’s and 529’s can both be used to fund tuition and fees for K-12 and higher education. But 529’s also allow for payment of related supply expenses and books, certain apprenticeship programs, homeschooling expenses, and even student loan payments (up to $10,000.) When using a 529 or ESA, it is important to carefully document the expenses for which you are using the funds.
The ESA also has some contribution restrictions that the 529 does not have. People with Modified Adjusted Gross Income (MAGI) of more than $110,000 if single or $220,000 for Married Filing Jointly (MFJ) cannot contribute to an ESA. At least at the Federal level, there is no income restriction for 529 plans. The ESA also has an age restriction for contributions: once a named beneficiary reaches age 18, contributions are no longer allowed with an ESA. There is no such restriction with a 529 at the Federal level (some states have some restrictions). Additionally, ESA funds must be used by age 30, whereas 529 funds can be used throughout life.
As mentioned above, it is certainly possible to fund both an ESA and a 529 for the same beneficiary, and if you have the ability to do so, there is no reason not to, at least from a tax perspective. IF you do not need the flexibility of use for the 529 for all of your education funds and want the flexibility of investment options of the ESA, you could certainly contribute first to the ESA until you reach the $2,000/year limit (per beneficiary), and then contribute additional funds to your chosen 529 plan. For example, if you can reasonably save $300/month for your family’s future educational needs, the first $2000 would go to the ESA, with the remaining $1600 for the year going to the 529 plan. This gives you flexibility on both the investment and the spending, and in this case, in almost equal proportions.
Choosing which plan to use, or how much to use each plan if both are to be used together, depends on your family’s specific goals and likely needs. It is important to map out these goals and actually put pencil to paper to determine your present and likely future financial realities.
A trained financial advisor or accountant can help with these activities, and there are also a lot of great resources available on the Internet on this topic, as well. Feel free to give us a call at 970-287-1818 if you would like to discuss this further with us.