Finding tax-free ways to save for college is a big deal for a large portion of the population, and for good reason. Obtaining a college education is one of the best ways for your dependents to secure a better job and a better life. However, despite different attempts to lower college tuition at both the state and Federal level, the cost of a college education continues to grow. US Student loan debt in America has reached nearly $1.5 trillion in 2018, equating to an overwhelming balance of more than $39,000 in debt per the average college graduate.
As a parent or guardian saving for college, you’re probably aware of the albatross that student loan debt can represent to a young graduate just starting out in their career. With so many tax-free ways to save for college these days, it may be a little intimidating to do the research on your own. We can help by providing a general overview of ways you can save for higher education while taking the maximum advantage of available tax deductions. Our hope is that this insight will assist you in moving forward confidently as you plan for the best for your children or grandchildren.
While it’s true that financial aid for college can come in many forms such as grants, scholarships, and work-study programs, most of financial aid for college comes from student loans. In most cases, developing a tax-free college savings program early on can be financially superior to taking out student loans once the interest is considered.
529 College Savings Plans
529 plans are a tried and true method of saving for college while also providing a smart tax shelter. Section 529 plans are sponsored by states, state agencies, and educational institutions to encourage individuals to save for college. 529 plans allow residents to buy small portions of tuition at today’s rates to be applied when the plan’s beneficiary attends a qualifying institution, regardless of when they attend. It is in this way that a 529 plan allows you to hedge your savings against the rising cost of college. 529 plans are unique in that they cover not only tuition expenses, but also room and board associated with attending a college or university.
529 plans don’t impose any annual contribution limits, however, the Internal Revenue Code (IRC) does have a mandated federal gift exclusion. As of 2018, contributors can bestow up to $15,000 annually per beneficiary and $30,000 annually for married couples making contributions to a 529 plan (15k from each spouse). Contributors can also take advantage of a special provision when initiating the 529 plan that allows you to contribute up to five years’ worth of annual gifts in the first year, adding up to a total of $75,000 you can give in year one. Lastly, you should check your state’s maximum 529 balance before getting started. While the amount varies, many states cut off contributions at the level that the state deems sufficient to cover the cost of a 4-year degree including books, room and board. This amount can range from $225,000 to over $500,000. Once the 529 contribution limit is reached, you will be unable to make any additional contributions to the plan.
2018 Changes to 529 plans
The Tax Cut and Jobs Act of 2017 also changed the way that 529 plans work. Under the new rules, 529 plans don’t just have to be spent on college. The funds in your 529 plan can be spent on qualified expenses for private, public, and religious K-12 schools. This is great news for many parents who choose to send their children or dependents to a private institution for their primary and secondary education. This eliminates the need to pay for private school out of your taxable investments, although the yearly withdrawal amount is capped at $10,000 per year for K-12 grade spending. IMPORTANT: It’s still unclear how many states will treat a tax-deductible contribution and tax-free distributions made during the same tax year. Be sure to contact your local CPA to ensure you are abiding by state, as well as IRS, rules.
Coverdell Education Savings Accounts
Formally known as Education IRAs, Coverdell Education Savings Accounts (ESAs) are another type of tax-advantaged savings vehicle that allow individuals to contribute to education expenses. Coverdell ESAs came very close to getting the “axe” by the Tax Cuts and Jobs Act of 2017, when House Republicans recommended eliminating the accounts, however Coverdell ESAs were not mentioned in the Senate revision or the final Act itself so are still a practical savings alternative.
Unlike 529 plans, Coverdell ESAs offer tax-free withdrawals for college, as well as K-12 educational expenses. Compared to the 529 plans, these types of tax shelters have a maximum of $2,000 per beneficiary contribution, per year. Despite this, Coverdell distributions are not subject to federal income tax, nor are withdrawals that are used for qualified expenses such as tuition, room, board, books, supplies, transportation, and computers.
For children or grandchildren with special needs, a Coverdell ESA can be maintained indefinitely, however, under all other situations, the account can only remain open until the beneficiary reaches 30 years old. After turning 30, the beneficiary can choose to take out the remainder as an unqualified withdrawal, subject to a 10% penalty, roll the balance into a 529 plan, or roll the balance into another Coverdell for a different family member.
Custodial accounts are another consideration when searching for college savings plans. A custodial account is a savings plan without contribution limits where an adult custodian maintains control of the funds in the account. Custodial Accounts come in two different varieties: the Uniform Transfers to Minors Act (UTMA) and the Uniform Gifts to Minors Act (UGMA). The primary difference is that a UGMA allows parents and grandparents to give funds to their children in money, life insurance, bonds, stocks, or annuities, while the UTMA gives the option to postpone distributions based on age limits in your state. Funds in a Custodial Account can be used for educational and non-educational expenses and a portion of any earnings may be tax-exempt. Additionally, some or all the earnings may be taxed at the child’s income rate.
Custodial accounts offer the advantage of having no contribution limits or withdrawal penalties, but it’s important to remember that anything over $14,000 is subject to IRC gift taxes. It’s safe to say that custodial accounts offer the most flexibility but provide the least amount of tax exemptions when compared to Coverdell and 529 plans.
Early Whole Life Insurance Coverage
Now with the normal, dull accounting strategies for saving for college out of the way, we’ll introduce two brilliant alternative methods for saving for college or private school that you may not have thought about. The first of these college savings plans is the early whole life insurance coverage for educational expenses. When you pay your whole life insurance premium every month, a portion goes to the death benefit and another portion to a separate cash-value account. Once your son or daughter begins college, you can then take out a loan against the cash balance. If you fail to pay back the loan, your insurer simply reduces your death benefit, but this is of little consequence if you are setting up the whole life insurance policy to pay for college education. Usually, the principle portions of these loans are tax-free as well. Whole life insurance coverage used to pay for college has two distinct advantages:
#1: The amount of money in your account doesn’t contribute towards financial aid, making it more likely that your child will qualify, and
#2: If they choose not to attend college, you’re not stuck with a tax penalty to remove the money as you would with a 529.
Employ Your Child in Your Business
Lastly, and by far the best way for small, family owned businesses to save for college, is to employ your child. The way this savings plan works is as follows: you employ your child in a business you own which offers a tax deduction for Federal income tax, as well as self-employment tax. Then you put the child’s earnings into the whole life insurance plan, the 529, or other tax deferred investment vehicle. This is a win-win for business owners as they save taxes on the front end, in addition to saving taxes on the back end as the educational investment accounts grow. This plan requires a little more planning, but because you are essentially doubling your tax savings, it’s truly a college savings plan on steroids.
Ask Your CPA about College Savings Plans
Selecting the best tax-free way to save for college can be a daunting task. By contacting a Lawhorn CPA professional before you decide, your accountant can ensure that you choose the best educational savings plan for your tax purposes and ensure that your beneficiary receives the maximum benefit from your generous gift. Contact Lawhorn CPA Group today to discuss your tax planning and savings initiatives to ensure you choose the best possible college savings plan and that it is in line with your personal tax plan. Call us at 865-212-4867 or contact us online HERE.
I am interested on your thoughts about Indexed Universal Life. I am looking into a policy for my 10 year old son for higher education or starting a business when he is older. I am structuring to allow for maximum cash value / minimum death benefit, keeping below the MEC threshold. Any carriers you recommend?
Mark, apologies for the delayed response. There are a few different factors that go into choosing the best carrier for you, and we have several that we could recommend to you. We’d love to meet with you to discuss the possibilities. Feel free to give us a call to schedule a consultation! 865-212-4867 Hope to hear from you soon!