Refresher on Tax-Smart College Savings Strategies for Parents
College costs lots of money these days, so saving for your college-bound child is a big deal. Saving in a tax-smart fashion can really help.
In this article, we explain the most helpful federal income tax breaks that are potentially available to college savers. Here goes.
College Is Expensive!
Data for the 2019-2020 academic year indicates that the average cost of tuition, fees, room, and board was $32,500. Here are some average sticker-price numbers:
- $12,720 for a public two-year institution at the in-state rate ($3,730 for tuition and fees plus $8,990 for room and board
- $21,950 for a public four-year institution at the in-state rate ($10,440 for tuition and fees plus $11,510 for room and board)
- $38,330 for a public four-year institution at the out-of-state rate ($26,820 for tuition and fees plus $11,510 for room and board)
- $49,879 for a private non-profit four-year institution ($36,880 for tuition and fees plus $12,990 for room and board)
Consequently, the average total price for a four-year degree is approximately $122,000.
- $87,800 for a public four-year institution at the in-state rate
- $153,320 for a public four-year institution at the out-of-state rate
- $199,500 for a private non-profit four-year institution
These numbers assume that your child will finish his or her undergraduate education in four years, but only 39 percent of students actually do that. Nearly 60 percent take six years. Yikes!
That said, most students receive at least some financial aid to offset the sticker price of their degrees.
Key point. Tax-smart college savings strategies can make college costs more manageable. So, let’s talk about those.
Contribute to a Coverdell Education Savings Account
You can set up a Coverdell Education Savings Account (CESA) to pay qualified education expenses for the account beneficiary (your college-bound child).
You can contribute up to $2,000 per year to the child’s CESA. If you have several children, you can set up a CESA for each of them.
Contributions are non-deductible, but earnings are allowed to accumulate free of any federal income tax. You can then take tax-free withdrawals to pay for the account beneficiary’s post-secondary tuition, fees, books, supplies, and room and board.
Maybe not for you. Your right to contribute is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 if you are unmarried, or between $190,000 and $220,000 if you are a married joint-filer.
If your MAGI is too high to allow a contribution, another person (such as a grandparent) can contribute to your child’s CESA.
Contribution deadline. You have until April 15 of the following year (adjusted for weekends and holidays) to make your CESA contribution(s) for the current tax year.
Contribute to a Section 529 College Savings Plan
A Section 529 college savings plan account offers valuable tax benefits and is also highly flexible. Here’s the story on these tax-favored accounts.
Section 529 college savings plans are state-sponsored arrangements named after the section of our beloved Internal Revenue Code that authorizes very favorable treatment under the federal income and gift tax rules.
You as the parent of a college-bound child begin by making contributions into a trust fund set up by the state plan that you choose. The money goes into an account designated for the beneficiary whom you specify (your collegebound child).
You can then make contributions via a lump-sum pay-in or via installment pay-ins stretching over several years. The plan then invests the money using the investment direction option that you select.
When your child reaches college age, you can take federal-income-tax-free withdrawals to pay eligible college expenses, including room and board under most plans. Plans will generally cover expenses at any accredited college or university in the country (not just schools within the state sponsoring the plan). Community colleges qualify as well.
In essence, a Section 529 college savings plan account is a tax-advantaged way to build up a college fund for your child.
Understand These Things
- Your child is not guaranteed admittance to any particular college.
- The cost to attend whichever school that is ultimately chosen is not locked in by the arrangement. See the later discussion of the important distinction between 529 college savings plans and 529 prepaid tuition plans.
- You are generally not guaranteed any minimum rate of return.
- Most college savings plans permit lump-sum contributions of well over $300,000. So, you can really jump-start your child’s college fund if you have enough available cash to do so. If not, you can make installment pay-ins over a number of years. Of course, the sooner you can put substantial dollars into the account, the sooner the tax-free compounding benefits start accruing.
- Section 529 college savings plans generally offer several investment direction options, including equity mutual funds and more conservative options like bond and money market funds.
- Plans generally welcome out-of-state investors.
Income Tax Advantages
The primary tax advantage of 529 college savings plan accounts is that they allow earnings to build up free of any federal income tax. You can then take federal-income-tax-free withdrawals to pay qualified college costs for the account beneficiary (your child).
Usually, there’s no state income tax hit on withdrawals when both the contributor (you) and the account beneficiary (your child) reside in the state sponsoring the plan. State income tax deductions or credits may be available for contributions to your in-state plan.
If you contribute to an out-of-state plan, the state income tax consequences can vary. Check with your tax pro for help with any state tax questions.
Estate Planning Advantages
Contributions to a Section 529 account reduce your taxable estate. For federal gift tax purposes, contributions are treated as gifts eligible for the $15,000 (for 2020) annual federal gift tax exclusion. In addition, you can elect to spread a large lump-sum contribution over five years and thereby immediately benefit from five years’ worth of annual gift tax exclusions.
For example, you can make a lump-sum contribution of up to $75,000 ($15,000 x 5) to a child’s 529 account without any federal gift tax consequences. Your spouse can do the same, so together you could contribute $150,000 ($75,000 x 2). Gifts up to these amounts will not reduce your $11.58 million (for 2020) unified federal gift and estate tax exemption or your spouse’s exemption, as long as you elect the five-year spread deal.
When funding an account for a child’s college education, you should always consider what will happen to your money if things go tragically wrong. After all, your child could decide to become a professional disc (think Frisbee) golfer and skip college altogether. Then what? Thankfully, 529 accounts are flexible enough to handle such adverse outcomes.
You can change the account beneficiary without any federal tax consequences, as long as the new beneficiary is a member of the original beneficiary’s family and in the same generation (or a higher generation).
Your children, your stepchildren, their spouses, and your nieces and nephews are all considered members of the same family and same generation. So, you can move money from an account set up for any one of these individuals into an account set up for any other of these persons with no federal income tax or gift tax consequences.
You also have flexibility to change plans or the 529 account’s investment direction. If, for example, you decide another state’s plan is superior to the current one, you can simply switch plans by rolling over the account balance. This can be done as often as once a year without any federal tax consequences. And plans can allow you to switch investment direction as often as twice in a calendar year.
Finally, what happens if you want or need to get your money back from the Section 529 plan? The federal tax rules allow this too. You will be taxed on any withdrawn earnings, and you also will owe a 10 percent penalty tax on any such withdrawn earnings. But that’s a relatively small price to pay for the privilege of being able to reverse a poor decision and recover your money.
Key point. The preceding discussion describes what the federal tax law allows. Section 529 plans usually conform to these guidelines, but they are not required to do so. Before investing, make sure any plan you are considering does conform.
Don’t Confuse Savings Plans with Prepaid Plans
Don’t mix up Section 529 college savings plans, which we have been explaining so far, with Section 529 prepaid college tuition plans—which we will give only a brief mention here. Both types of plans are properly called “Section 529 plans” because both are authorized by that section of the Internal Revenue Code. Both receive the same favorable federal tax treatment. But that’s where the resemblance ends.
The big distinction is that prepaid tuition plans lock in the cost to attend certain colleges. In other words, the rate of return on a prepaid tuition plan account is promised to match the inflation rate for costs to attend the designated school or schools—nothing more, nothing less. That’s okay if that’s what you really want.
In contrast, a 529 college savings plan allows you to benefit if the account earns more than the rate of inflation for costs to attend the college that our child ultimately chooses.
Earnings greater than the inflation rate mean less money needs to be invested to fully fund the child’s future college costs. Good! Of course, there’s no guarantee here.
You can actually lose money with a college savings plan, and that happened to some folks during the 2008-2009 financial crisis. But incurring an overall loss is probably unlikely if you make most of your contributions when your child is still years away from college.
With enough time on your side and the right investment strategy, you can reasonably hope that a 529 college savings account’s rate of return will exceed the rate of inflation for college costs. If you are wary of making that assumption, consider either a prepaid tuition plan or a savings plan that offers suitably conservative investment options.
Key point. When you read about Section 529 plans, you are almost certainly hearing about college savings plans and not about prepaid tuition plans. It’s important to understand the difference.
Which Section 529 Plan Is Best?
That’s for you to decide. The main consideration should be how closely a particular plan’s investment options conform to your preferences. Of course, a plan that charges low management fees is best, all other things being equal. If contributing to the in-state plan would deliver significant state tax benefits, that could be a deciding factor.
Section 529 plans are competitive, and states are constantly changing their plans by, for example, offering wider arrays of investment options. In evaluating plans, work with the most current information. A good source is www.savingforcollege.com.
No Kiddie Tax on Section 529 Plan
You don’t have to worry about the kiddie tax if you set up a custodial 529 plan in the child’s name. The 529 plan is an investment plan where the monies remain in the plan. You make contributions with after-tax dollars.
When the child takes the money out of the plan for college, he or she does so tax-free when the funds are used to pay for qualified higher education expenses.
Considering the Kiddie Tax in a Taxable Plan
Back in the “good old days,” it was possible to save taxes by investing your child’s college fund in the child’s name rather than in your own name. That way, you could benefit from the child’s lower federal income tax rates on the college fund’s investment income. This strategy is called “splitting income with your child.”
The concept of splitting income is simple. First, you make gifts to your college-bound child’s college fund custodial account (not a Section 529 account). Under the $15,000 annual gift tax exclusion (for 2020), you can give up to that amount each year to the college fund without paying any federal gift tax and without using up any of your $11.58 million (for 2020) unified federal gift and estate tax exemption. Your spouse can do the same.
You then, on behalf of your minor child, invest the college fund money. The resulting income and gains are taxed to your child at his or her lower tax rates. The college fund compounds that much quicker, because the after-tax rate of return is that much higher. So far, so good.
Beware of Kiddie Tax Threat
Unfortunately, you must watch out for the dreaded kiddie tax when you save for college in your child’s name. The kiddie tax can tax part of your child’s investment income at the parent’s (your) marginal federal income tax rate, which can be up to 37 percent for net short-term capital gains and interest income (for 2020) and up to 20 percent for net long-term capital gains and dividends (for 2020).
Your marginal rates are probably much higher than the rates that would otherwise apply to your child’s college fund investment income—typically 10 percent or 12 percent for net short-term capital gains (for 2020) and 0 percent for net long-term capital gains and dividends (for 2020).
The good news is that the kiddie tax calculated at your marginal rate applies to the amount of your child’s investment income that exceeds the annual kiddie tax threshold, which is $2,200 for 2020.
Beat the Kiddie Tax
For ideas on how to beat or at least substantially defang the kiddie tax, see Defeating the Kiddie Tax after the TCJA Tax Reform. This article was written when the kiddie tax was based on the onerous trust tax rates, but the tax reduction principles in the article apply today when you are trying to avoid the tax at your higher rate.
For how the trust rates disappeared from the kiddie tax, see Congress Kills TCJA Kiddie Tax Changes.
Save for College with Your Taxable Investment Account
You can always choose to save and invest for a child’s college expenses by using a taxable brokerage firm account set up in your name as a college fund.
For 2020, the maximum federal income tax rate on net long-term capital gains and qualified dividends is 20 percent for higher-income folks, but most folks will pay no more than 15 percent.
If the 3.8 percent net investment income tax (NIIT) applies, the effective federal income tax rate can rise to 23.8 percent (for 2020). Paying these relatively low tax rates on your college fund’s capital gains and dividends is a reasonable deal.
College is expensive. Data for the 2019-2020 academic year indicates that the average cost of tuition, fees, room, and board was $30,500.
If your MAGI is less than $95,000 (single) or $190,000 (married), the Coverdell plan is a good college savings plan for you to consider.
But the real hummer is the Section 529 savings plan, because it’s available to all taxpayers with no income limitation or phaseout as you face with the Coverdell plan. Special rules allow you to put up to $75,000 ($150,000 if married) to kick-start the tax-free earnings that you then withdraw from the plan tax-free to pay for college.
Remember that the Section 529 plan comes in two varieties: savings plans and prepaid plans.
Prepaid plans work in much the same manner as savings plans, except the prepaid tuition plan has its rate of return tied to the tuition rate of the designated school or schools.
The kiddie tax does not apply to Section 529 plans.
If you use the income-splitting technique with your child to increase the after-tax results of a non-tax-advantaged savings plan, make sure to consider and do what you can to avoid the kiddie tax.
And of course, you can always set up a standard brokerage account and label and maintain it as a college fund.
Deduct Student Loan Interest If Your Income Permits
Our beloved Internal Revenue Code allows an above-the-line deduction for interest on qualified education loans. “Above-the-line” means you need not itemize to benefit.
But the deduction is capped at a maximum annual amount of $2,500, and there are income limits.
To qualify for the interest deduction, the debt must be incurred within a reasonable time before or after eligible higher education expenses are incurred. Eligible expenses are defined as tuition, fees, room and board, and related expenses (such as books and supplies) for the taxpayer, the spouse, or any dependent of the taxpayer (such as your college child) to attend an eligible educational institution.
The deduction is allowed only for expenses attributable to a year during which the student carries, for at least one academic period beginning in that year, at least half of a full-time course load in a program that would ultimately result in an associate’s degree, a bachelor’s degree, or some other recognized credential.
The deduction for 2020 is phased out for unmarried taxpayers with MAGI between $70,000 and $85,000. If you are a married joint-filer, the phaseout range for 2020 is between MAGI of $140,000 and $170,000.
If you won’t qualify for the interest deduction because your income is too high, the next best thing is to arrange for your child—the student—to get the deduction by taking out the student loan in his or her own name.
But no deduction is allowed to your child if he or she is your dependent for the year—even if your child is totally on the hook for the loan and pays the interest with his or her own money.
You can finesse this issue by scheduling the start date for loan repayments after graduation. By then, your child should be self-supporting and no longer your dependent. Fingers crossed!