As parents identify ways to save for college, it is important to know that all strategies are not created equal. The best savings vehicles offer special tax advantages if the funds are used to pay for college. Tax-advantaged strategies are important because over time, you can potentially accumulate more money with a tax-advantaged investment compared to a taxable investment.
Since their creation in 1996, 529 plans have become to college savings what 401(k) plans are to retirement savings — an indispensable tool for saving money for a child’s or grandchild’s college education. But there is more than one way to save for college in a tax efficient manner. In addition to 529 plans, the list below highlights several other tax-advantaged college saving strategies to choose from.
Before 529 plans, there were custodial accounts. A custodial account allows your child to own assets—under the watchful eye of a designated custodian—that he or she ordinarily wouldn’t be allowed to hold in his or her own name. The assets can then be used to pay for college or anything else that benefits your child (summer camp, braces, piano lessons, computer, etc.).
A custodial account provides the opportunity for some tax savings, but the kiddie tax reduces the overall effectiveness of custodial accounts as a tax-advantaged college savings strategy. And there are other drawbacks. All gifts to a custodial account are irrevocable. Also, when your child reaches the age of majority (as defined by state law, typically 18 or 21), the account terminates and your child gains full control of all the assets in the account. Some children may not be able to handle this responsibility and may not use the money for college.
Coverdell Education Savings accounts (ESA)
Coverdell ESAs can be set up at most financial institutions to pay for qualified education expenses. Like 529 plans, Coverdells allow money to grow tax-deferred, and withdrawals are tax-free at the federal level and most often at the state level. Coverdell benefits apply to higher education expenses, as well as elementary and secondary education expenses. If the money is used for nonqualified expenses, you will owe tax and a 10% penalty on earnings.
Coverdell contributions are not deductible, and contributions must be made before the beneficiary reaches age 18 (unless he or she is a special needs beneficiary, as defined by the IRS). While more than one Coverdell can be set up for a single beneficiary, the maximum contribution per beneficiary per year is limited to $2,000. To contribute fully to a Coverdell in 2019, your modified adjusted gross income must be less than $95,000 as a single filer or less than $190,000 as a married couple filing jointly.
U.S. savings bonds
Series EE and Series I bonds are types of savings bonds issued by the federal government that offer a special tax benefit for college savers. The bonds can be easily purchased from many banks and savings institutions, or directly from the federal government. They are available in face values ranging from $50 to $10,000. You may purchase the bond in electronic form at face value or in paper form at half its face value.
If the bond is used to pay qualified education expenses and you meet income limits (as well as a few other minor requirements), the bond’s earnings are exempt from federal income tax. The bond’s earnings are always exempt from state and local tax.
In 2019, to be able to exclude all of the bond interest from federal income tax, married couples must have a modified adjusted gross income of $121,600 or less at the time the bonds are redeemed (cashed in), and individuals must have an income of $81,100 or less. A partial exemption of interest is allowed for people with incomes slightly above these levels.
The bonds are backed by the full faith and credit of the federal government, so they are a relatively safe investment. They offer a modest yield, and Series I bonds offer an added measure of protection against inflation by paying you both a fixed interest rate for the life of the bond (like a Series EE bond) and a variable interest rate that’s adjusted twice a year for inflation. However, there is a limit on the amount of bonds you can buy in one year, as well as a minimum waiting period before you can redeem the bonds, with a penalty for early redemption.
Though technically not a college savings account, some parents use Roth IRAs to save and pay for college. In 2019, you can contribute up to $6,000 per year. Earnings in a Roth IRA accumulate tax deferred. Contributions to a Roth IRA can be withdrawn at any time and are always tax free. For parents age 59½ and older, a withdrawal of earnings is also tax free if the account has been open for at least five years. For parents younger than 59½, a withdrawal of earnings—typically subject to income tax and a 10% premature distribution penalty—is spared the 10% penalty if the withdrawal is used to pay for a child’s college expenses.
But not everyone is eligible to contribute to a Roth IRA—it depends on your income. In 2019, if your filing status is single or head of household, you can contribute the full $6,000 to a Roth IRA if your MAGI is $122,000 or less. And if you’re married and filing a joint return, you can contribute the full $6,000 if your MAGI is $193,000 or less.