Do you remember the moment you first held your newborn in your arms? You held him close, promised to protect him, and in the back of your mind wondered, “How the heck am I going to afford to send you to college?” Okay, maybe paying for your child’s college education didn’t cross your mind right at that moment, but it’s on the mind of many parents, especially with the news filled with stories about the rising cost of a college education and the growing problems with student loan debt. Many new parents wonder where to start planning for their kid’s education, Here is a quick guide to saving for their future.
The 529 Plan
Named after section 529 of the Internal Revenue Code, a 529 plan may also be known as a qualified tuition program, or QTP. For federal income tax purposes, putting money into a 529 plan won’t result in any tax savings now. However, the earnings and distributions are tax-free as long as they are used to pay for eligible college expenses.
Because 529 plans are administered by the states, every state handles them differently. Fortunately for Arizonans, our state’s rules are some of the easiest in the country. Qualified distributions from Arizona and non-Arizona 529 plans are exempt from state income tax. In addition, while many states only offer a tax deduction for contributions made to their own state’s plan, Arizona allows a deduction on your state income tax return for contributions made to any 529 plan. So whether you started a plan in another state before moving to Arizona or you prefer another state plan’s investment options and fee structure, you’ll still get the deduction on your Arizona return. That deduction is up to $4,000 for married couples filing jointly and $2,000 if filing single or head of household. You don’t have to be the parent to take the deduction, either. Grandparents and other family members who contribute to the plan are eligible for the tax savings as well.
What happens if your child receives a scholarship and doesn’t need the funds within the plan? The 529 plans is flexible. You can (1) save that 529 funds for a future use such as graduate school, (2) change the beneficiary to another member of the family or roll the funds over into another plan or (3) withdraw the extra funds. If you choose to withdraw, the earnings in your account will be subject to tax, but you will avoid the 10% federal tax penalty for a non-qualified withdrawal. Note that the tax and penalty are only calculated on the earnings in the plan, you are never taxed on your original contributions to the plan.
Education Savings Accounts (Coverdell)
Unlike the 529 Plan, the Education Savings Account (ESA) can be used to save for K-12 expenses as well as higher education, great for families choosing private school. Another reason some parents prefer an ESA over a 529 Plan is investment flexibility: while many 529 Plans offer only single investment portfolio based solely on your child’s age, with an ESA you can customize your portfolio, choosing investments on your own.
The federal tax treatment of ESAs and 529 plans are generally the same. There is no deduction for contributions on your federal return, but withdrawals used to pay for a beneficiary’s qualified education expenses are free from income tax. However, where Arizona allows a deduction to your state income taxes for 529 plan contributions, no deduction is available for ESA contributions.
ESAs also have different annual contributions limits and restrictions. The annual contribution limit for an ESA is $2,000 per beneficiary. That is considerably less than the contribution limit for most 529 plans. The Arizona 529 plan has established a maximum account balance limit of $412,000 per beneficiary. Annual contributions to a 529 plan are not limited, but may be subject to gift tax if you contribute more than $14,000 per beneficiary, per year. The gift tax and estate planning considerations of 529 plans is beyond the scope of this article, so just keep in mind in you plan on contributing more than $14,000 to a 529 plan in one year, you’ll want to discuss it with a tax professional to make sure you’re in compliance with gift and estate tax laws.
Another potential drawback of the ESA is that you may not be able to contribute if your income is too high. The allowable contribution is gradually phased out if your income is between $190,000 to $220,000 for joint filers.
With all of these additional limits and restrictions on ESAs, it is easy to see why they have been overshadowed by 529 plans, but if more investment flexibility and the ability to save for K-12 expenses is important to you, the ESA is worth a look. Investing and taxes are never simple, but don’t let all of these choices prevent you from saving for your child’s education. Talk to your bank, your financial advisor, or check out the Arizona Family College Savings Program’s website to get started today.