Summer Savings: Consider the Tax Advantage of Coverdell ESAs and 529 Savings Plans

Jul 14, 2022

By Theresa Cagle Fry, Senior Vice President and Manager of IRAs, Retirement & Education Planning

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With summer vacations in full swing, the last thing kids want to think about right now is school. In a few short weeks though, back to school reminders will be everywhere you turn.  The excitement and adventure of a new school year are right around the corner.

If you have the dream of putting your children or grandchildren through college, you will need a plan for how you will save and a sensible investment strategy. College tuition could be one of the largest expenditures you ever make. If you have more than one child, the financial commitment is even  greater.  If your goal seems overwhelming right now, with proper planning and saving you can put the cost of college, or other post-high school education, within your reach.

There are a number of factors to consider before starting an education savings strategy and a range of investment options to sort through. Consider first the advantages of tax-deferred education savings programs, such as Coverdell Education Savings Accounts (ESAs) or 529 Savings Plans (529s).

Coverdell Education Savings Accounts (ESAs)
ESAs can be used to save for any level of education – from elementary school to graduate school. Not everyone can fund an ESA. There are income limits that may exclude mid to upper income families.   For those who are eligible, after-tax dollars deposited into an ESA have the opportunity to grow tax-  deferred and can be withdrawn income tax free, as long as withdrawals are used to pay the beneficiary’s qualified education expenses.

ESAs allow parents and family members to contribute up to $2,000 per student, per year, until the student reaches age 18.  In addition, if there is a balance in the ESA when the beneficiary reaches age 30, it must be distributed within 30 days unless it is for a special needs student. Distributions that are not used for educational purposes, at age 30 or otherwise, will have tax implications. The earnings distributed will be taxable income to the student and will be subject to a 10% penalty. Taxes and penalties can be avoided if the ESA is rolled into a 529 plan or into an ESA for a family member.

529 Education Savings Plans (529s)
A 529 Education Savings Plan is a tax-advantaged savings plan sponsored by a state that is designed to provide tax-free savings for future education costs. 529 plans can be used for K-12 tuition expenses at public, private, or religious schools (up to $10,000 per year) and for a variety of qualified expenses to attend colleges, universities, vocational schools, trade schools and other post-secondary educational institutions. 529s are open to anyone and can be used by the student at any educational institution they choose.

Each state that sponsors a 529 plan will determine the lifetime maximum that may be saved per student, the investments available, costs, and the state tax benefits available to the contributor.  Most states will only offer state income tax credits or deductions if you invest in your state’s plan, regardless of where the student attends college. For federal income tax purposes, contributions are not tax deductible.

There are no income or age limits to qualify to save using a 529 plan. You can open a 529 plan for anyone – your child, grandchild, friend, or even yourself. In most cases, multiple people can contribute to the same 529 savings plan. Contributions are considered gifts and are subject to gift tax rules which require you to file a gift tax return for gifts over $16,000 to anyone besides your spouse. Married couples can gift up to $32,000 a year to the same individual. However, there is a special provision for 529 savings plans that allows five years of accelerated gifts to be made. With advance gifting, up to $160,000 can be contributed per student by a married couple or $80,000 for single tax payers. Keep in mind that if you use the advance gifting strategy, no additional gifts can be made to the same student in the current and following four years.

In addition to the typical college costs such as tuition and fees, room and board, books and supplies, tax- free qualified withdrawals can also be used for enrollment or attendance in a registered apprenticeship program, and up to $10,000 can be used for repayment of outstanding student loans (for the student or the siblings of the student). Non-qualified withdrawals, however, can cause both federal and state income tax liabilities.  Earnings distributed in a non-qualified withdrawal will be taxable and subject to a 10% penalty on your federal income tax return.  For state income tax purposes, a non-qualified withdrawal can cause the recapture of previously provided state income tax credits or deductions.

Whether high school graduation is years away or right around the corner, having a plan and investment strategy for how to help offset the increasing cost of education is the first step. Take some time to discuss Coverdell ESAs, 529 savings plans, and other ways to save for future education costs with a financial advisor today.

Benjamin F. Edwards does not provide legal or tax advice, therefore it is also important to consult with your legal and tax professionals for additional guidance tailored to your specific situation.