Educational Savings Plan
As a parent with young children, you are faced with many rewards and challenges. One of these challenges may be saving for the high cost of a college education. However, there are two tax-favored options that might be beneficial: a qualified tuition program (QTP) and a Coverdell education savings account (ESA). In addition, you might also want to invest in U.S. savings bonds that allow you to exclude the interest income in the year you pay the higher education expenses. Each of these options has its benefits and limitations, but the sooner you choose to make the investment in your child’s future, the greater the tax savings.
Qualified Tuition Program (QTP)
A qualified tuition program (also known as a 529 plan for the section of the Tax Code that governs them) may be a state plan or a private plan. A state plan is a program established and maintained by a state that allows taxpayers to either prepay or contribute to an account for paying a student’s qualified higher education expenses. Similarly, private plans provided by colleges and groups of colleges allow taxpayers to prepay a student’s qualified education expenses. These 529 plans have, in recent years, become a popular way for parents and other family members to save for a child’s college education. Though contributions to 529 plans are not deductible, there is no income limit for contributors.
529 plan distributions are tax-free as long as they are used to pay qualified education expenses for a designated beneficiary. As much as $10,000 of distributions may be used for enrollment at a public, private, or religious elementary or secondary school. Qualified higher education expenses include tuition, required fees, books and supplies. For someone who is at least a half-time student, room and board also qualifies as a higher education expense.
For any distribution made after 2018, qualified education expenses of 529 plans include certain expenses associated with registered apprenticeship programs and qualified student loans. Apprenticeship program expenses include fees, books, supplies, and equipment required for the participation of the designated beneficiary in a registered and certified apprenticeship program with the Department of Labor. Qualified education expenses of 529 plans include up to $10,000 of principal or interest on any qualified student loan of the designated beneficiary or a sibling (brother, sister, stepbrother, or stepsister).
Under the SECURE Act 2.0 of 2022, beginning in 2024 the amounts held in a 529 plan of a designated beneficiary at least 15 years may be rolled over to a Roth Individual Retirement Account (IRA) of the same beneficiary and excluded from gross income. The distribution cannot exceed the aggregate amount contributed to the 529 account (including earnings) made in the previous five years. Also, there is an aggregate lifetime limit of $35,000 on such rollover distributions with respect to the designated beneficiary. The rollover distribution counts toward the annual Roth IRA contribution limit ($7,000 for an individual under age 50 in 2024).
Louisiana START Saving Program
The START Saving Program was created by the State of Louisiana. Its main purpose is to help families contend with the future high costs of their children’s or grandchildren’s college or vocational education. Parents, grandparents, and others who want to assist in funding a child’s education are encouraged to establish an education savings account through the START Saving Program for each child (the account beneficiary) and to make regular deposits to those accounts. In addition to deposits made by account owners, the state allocates Earnings Enhancements (state matching grant dollars) to eligible accounts. Both account owner deposits and Earnings Enhancements are invested to earn interest and maximize the value of every dollar saved. Account owners may select one or more investment funds ranging from the very conservative Principal Protection Fund (fixed income) to more aggressive equity funds offered through the Vanguard Group. Upon the beneficiary’s enrollment into an approved postsecondary institution, funds are disbursed to cover their Qualified Higher Education Expenses (QHEE), which include tuition, fees, books, supplies, certain required equipment, reasonable charges for room and board, and special needs services.
Earnings on START accounts are tax deferred until withdrawn. If the funds are used to pay Qualified Higher Education Expenses, the earnings are exempt from both state and federal taxes. Deposits to START accounts are deductible from reported Louisiana income, up to $2,400 per year, per beneficiary. Unused portions may be carried forward to subsequent tax years. Married couples filing jointly may deduct deposits to START accounts from Louisiana State Taxable Income up to a maximum of $4,800 per year, per beneficiary, and any unused portion may be carried forward to subsequent tax years.
Coverdell Education Savings Accounts
Coverdell education savings are custodial accounts similar to IRAs. Funds in a Coverdell ESA can be used for K-12 and related expenses, as well as higher education expense. The maximum annual Coverdell ESA contribution is limited to $2,000 per beneficiary, regardless of the number of contributors. Excess contributions are subject to an excise tax.
Entities such as corporations, partnerships, and trusts, as well as individuals, can contribute to one or several ESAs. However, contributions by individual taxpayers are subject to phase-out depending on their adjusted gross income (AGI). The annual contribution starts to phase out for married couples filing jointly with modified AGI at or above $190,000 and less than $220,000 and at or above $95,000 and less than $110,000 for single individuals.
Contributions are not deductible by the donor and distributions are not included in the beneficiary’s income as long as they are used to pay for qualified education expenses. The earnings accumulate are tax-free. Contributions generally must stop when the beneficiary turns age 18, except for individuals with special needs. Parents can maximize benefits by transferring the older sibling’s account balance to a younger brother, sister or first cousin, thereby extending the tax-free growth period.
U.S. Savings Bonds
If you redeem qualified U.S. savings bonds and pay higher education expenses during the same tax year, you may be able to exclude some of the interest from income. Qualified bonds are series EE savings bonds issued after 1989, and Series I bonds (first available in 1998). The tax advantages are minimized unless the redemption of the bond is delayed a number of years, therefore some planning is required.
The exclusion is available only for an individual who is at least 24 years of age before the issue date of the bond and is the sole or joint owner with a spouse. Therefore, bonds purchased by children or bonds purchased by parents and later transferred to their children, are not eligible for the exclusion. However, bonds purchased by a parent and later used by the parent to pay a dependent child’s expenses are eligible. The exclusion is, however, phased out and eventually eliminated for high-income taxpayers.
Educational Assistance
Benefits to maintain or improve job skills are excludable from an employee’s income if paid directly to the educational institution or are deductible by an employee if reimbursed by an employer. In addition, an employee can exclude from gross income up to $5,250 of employer-provided educational assistance provided under an educational assistance program if nondiscrimination requirements are met. Employees can qualify for the exclusion even if the payments are for graduate level course work, including courses leading to a professional degree. The maximum dollar limit on an educational assistance program includes contributions towards an employee’s student loans until 2026.
Of course, in planning for higher-education costs, parents may also choose to use funds from an IRA or a traditional form of savings. In addition, higher education costs may be supplemented with scholarships, loans, and grants. However, having a viable plan as early as possible in a child’s life will make maximum use of a family’s financial resources and may provide some tax benefit.
If you would like to explore how these opportunities can work for you and have us fully evaluate your situation, please do not hesitate to call us or reach out to your CPA professional today.