College Planning—Part I – Strategies For Accumulating Funds
Our next series will address topics related to the challenges associated with funding a post-secondary education. These could include four year college, junior/community colleges and trade schools. In addition, most of the concepts could also be applied to a graduate school education as well. Today we will look at some strategies for accumulating funds to pay for education. Congress has provided several tools that reduce or eliminate the “income tax drag” associated with growing these balances. For most of our country’s existence, there were no specialized accounts and no tax breaks available to help parents and students accumulate funds. Generally, education costs were paid from savings and investment accounts that were not necessarily earmarked for schooling.
College costs began to sky-rocket in the 1990’s and Congress took note of the need to help taxpayers with this challenge. Their first attempt in 1997 tried to mimic Individual Retirement Accounts (IRA’s) so the vehicle was named an Education IRA. It soon became obvious that this was a confusing moniker and in 2002, they were renamed Coverdell Education Savings Accounts (ESA), in honor of Senator Paul Coverdell of Georgia. The rules governing Coverdell ESA are spelled out in Internal Revenue Code Section 530.
Contributions to ESA’s are not deductible but are classified as “Tax-deferred”. This means that any growth on contributed amounts is not taxed each year. Rather, it is permitted to grow within the ESA with the desired outcome being that the account balances are distributed to pay qualified education expenses of the account “beneficiary” (who is usually, but not always a dependent of the account “owner”). If utilized in such a way, the account growth is distributed tax-free, thus making greater sums available for education.
Not everyone is eligible to open and contribute to Coverdell ESA accounts and there are other limitations. Single taxpayers with Modified Adjusted Gross Incomes below $95,000 are eligible to make the full annual contribution of $2,000. Single taxpayers with incomes between $95,000 and $110,000 fall into a phase-out range with incomes exceeding $110,000 not eligible for any contribution at all. The comparable income phase-out range for married taxpayers filing jointly is $195,000 to $220,000. Contributions can be made to Coverdell ESA accounts until the beneficiary attains age 18 and the account must be emptied by age 30. Most financial institutions will offer these accounts and investment options include stocks, bonds, mutual funds, exchange traded funds (ETF’s), similar to what might be available for a traditional or Roth IRA.
Attentive readers will note that with college education costs often exceeding $100,000 (and multiples thereof), the $2,000 annual contribution limit for Coverdell ESA’s is a hindrance to accumulating sufficient funds. Section 529 Savings plans address this shortcoming. These plans are offered and managed by nearly every state and offer total accumulation ceilings of $235,000, not to exceed expected education costs. There are no income limits for eligibility and annual contribution caps are limited by the IRS annual gifting rules. There is even a provision for “bunching” multiple years of contributions into one tax year if the account owner desires to “superfund” the 529 account. There are no beneficiary age restrictions for contributions, nor must the account be empty by age 30.
Because these 529 plans are offered and managed by individual states, there can be significant variations and some states even offer multiple plans. Many will provide a state income tax deduction for contributions by in-state taxpayers, but these same deductions may be subject to recapture if the funds are moved to another state’s plan. The investment choices are determined by the state and the breadth of investment options and their expenses can vary. So, while 529 plans overcome some of the shortcomings of the Coverdell ESA, they may come with some of their own.
One significant difference between section 529 accounts and Coverdell ESA’s is in the definition of a qualified education expense, particularly concerning grade levels. Coverdell ESA accounts can be used for qualified education expenses (K-12 and up) of the beneficiary regardless of grade level. For many years, the tax rules for 529 plans limited their qualified use to post-secondary education only. The Jobs and Tax Cut Act of 2017 expanded the possible uses of 529 funds to K-12 tuition, but not every state legislature has approved this change. For example, Colorado does not consider K-12 expenses as qualified education expenses and cautions account owners from using Colorado 529 plan assets for this purpose. Thus, the definition of what constitutes a qualified education expense is not uniform between states nor across plan types. It is sad that politics have come into play regarding our children’s educations, but that is the reality at the present time. These differences point out the importance of seeking top notch tax and financial planning advice when considering these financial tools.