StateTrust has extensive experience in helping clients design strategies to meet future higher educational expenses for designated beneficiaries.
Educational 529 Plan
Named after section 529 of the United States Internal Revenue Code, a 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions.
There are two types of 529 plans:
- Pre-Paid Tuition Plan. Allows one to purchase tuition credits, at today's rates, to be used in the future and therefore, their performance is based upon tuition inflation. This plan allows college savers to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and board. Most prepaid tuition plans are sponsored by state governments and have residency requirements. Many state governments guarantee investments in pre-paid tuition plans that they sponsor.
- College Savings Plan. Growth for this plan is based upon market performance of the underlying investments. An account holder may typically choose among several investment options for his or her contributions, which the college savings plan invests on behalf of the account holder. Investment options often include stock mutual funds, bond mutual funds, and money market funds, as well as, age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any college or university. Investments in college savings plans are not guaranteed by state governments and are not federally insured.
Advantages of 529 Plans
While most plans allow investors from out of state, there can be significant state tax advantages and other benefits, such as matching grant and scholarship opportunities, protection from creditors, and exemption from state financial aid calculations for investors who invest in 529 plans in their state of residence.
Most 529 savings plans offer a variety of age-based asset allocation options where the underlying investments become more conservative as the beneficiary gets closer to college age.
With the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), 529 plans gained their current prominence and tax advantages. Distributions from 529 plans for qualified higher education expenses are exempt from federal income tax.
There are many advantages to a 529 plan:
- They provide a very easy and effective way to save for college.
- Many states provide state income tax deductions for all or part of the contributions of the donor.
- The principal grows tax-deferred and distributions for the beneficiary's college costs are exempt from taxation.
- The donor maintains control of the account.
- Allows transferability of unused amounts to other qualified members of the beneficiary's family without incurring any tax penalty.
Disadvantages of 529 Plans
There are some disadvantages for 529 Plans:
- Only a single exchange/reallocation of assets per year in a 529 plan is allowed under the IRS ruling.
- The earnings portion of money withdrawn from a 529 plan that is not spent on eligible college expenses will be subject to income tax and an additional 10% federal tax penalty, and the possibility of a recapture of any state tax deductions or credits taken.
- The 529 account is counted as an asset that may affect the eligibility of financial aid (loans and grants). If the 529 account is under the parents or the student, then the financial aid office will only take into consideration 5.64% of the entire value for calculating the expected family contribution. A potential workaround is for the plan owner to be someone other than the student or the parent (such as a grandparent).
Educational IRA
The Education IRA, also known as Coverdell Education Savings Accounts or simply "ESA", is a tax-advantaged investment account in the United States designed to encourage savings to cover future education expenses (elementary, secondary or college), such as tuition, books, uniform, etc.
The following Table describes the principal characteristics of an Educational IRA plan:
| # | Characteristics of an Educational IRA |
|---|---|
| 1. | A nondeductible, cash contribution up to $2,000 can be made once a year for each beneficiary before they turn 18 years old. |
| 2. | You can open more than one IRA for each individual but the contribution limit will stand at $2,000 per year. It must be designated for qualified higher-education expenses such as fees, school supplies and equipment, tuition (eligible post-secondary institute), room and board, and textbooks. Elementary and secondary school expenses are now included. |
| 3. | Withdrawals are tax-free. Any IRA earnings are tax-free provided that annual expenses amount to more than the withdrawals. In a case where annual expenses are higher than the IRA distribution, the beneficiary would be required to pay income tax on either all of the earnings or a portion thereof. |
| 4. | Money left in the IRA when a beneficiary turns 30 years old will incur taxes along with a 10% penalty. |
| 5. | You cannot make contributions to an Education IRA if you pay into a qualified state tuition program. |
The tax treatment of an Educational IRA allows money to grow tax deferred and proceeds to be withdrawn tax free for qualified education expenses at a qualified institution.
US Series EE Savings Bonds
US Savings Bonds are another investment option that could be used to help you save for college expenses. Interest earnings on certain US savings bonds are completely tax free if you use the money to pay your child's qualified higher education expenses. However, there is a ceiling on the amount of income your family can be earning at the time you cash in the bonds to qualify for the tax break. There are also other restrictions on purchase and ownership.
Series EE US Savings Bonds are safe, low-risk savings products that pay interest based on current market rates for up to 30 years. These bonds have the following characteristics:
- Series EE Savings Bonds issues dated May 2005 and after will earn a fixed rate of interest. EE/E Bonds you purchased between May 1997 and April 30, 2005, earn a variable market-based rate of return.
- They are an accrual-type security, which means interest is added to the bond monthly and paid when you cash in the bond.
- Electronic bonds purchased are sold at face value. Minimum purchase amount is $25 and maximum per calendar year is $5,000.
- Minimum term of ownership: 1 year. Early redemption penalties apply before 5 years (forfeit of 3 most recent months' interest). No early redemption penalty applies after 5 years.
- Interest earnings are subject to Federal income tax but may be excluded from Federal income tax when used to finance educational expenses.
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