Are you looking for college savings strategies? Whether you just started a family or already have a growing clan, it’s important to take a proactive approach to saving for college. College tuition inflation averaged 12% each year from 2010 to 2022, with these trends expected to continue over the next few decades.
Saving for your child or grandchild’s future can also lead to exclusive tax benefits. In this article, we’ll explore different options for saving for college, including how you can leverage tax-advantaged plans to lower your income and generate tax-free growth.
Tax-Advantaged Options
There isn’t a one-size-fits-all approach when it comes to saving for college. In fact, the tax-advantaged plan that works best for your situation is dependent on your goals, investment timeframe, and where you live. Here are three tax-advantaged college savings options to consider:
529 Plans
A 529 plan is a college savings account that offers tax-free withdrawals when funds are used toward education expenses. In addition, many states, including Illinois, offer a tax deduction for qualifying contributions. There is no limit to the amount you can contribute in any given year, but some states have lifetime contribution limits, and if you happen to contribute more than than the annual gift tax limit ($18,000 for 2024), a gift tax filing will be required.
When it comes to choosing a 529 plan, it’s best to shop around. You aren’t required to establish a 529 in your home state. Instead, you can purchase a plan from any state. Many are wary of contributing to a state sponsored 529 plan because they don’t know if their child will go to an in-state school. State sponsored 529 plans can generally be used for most out-of-state schools as well, so look into the eligible state sponsored 529 plans that can offer a tax deduction for contributing!
If you have a lot of money to put toward saving for college, you can “supercharge” your 529 plan. This involves making a few year’s worth of contributions in one year, then spreading the amounts contributed over five years. Your money will have more time to grow without triggering a gift tax, although a gift tax return will be required.
Coverdell Education Savings Accounts
A Coverdell education savings account is a tax-advantaged education savings account. Unlike many 529 plans, Coverdell education savings accounts can pay for expenses that 529 plans might not cover, like, equipment, academic tutoring, and special needs services. Funds contributed to Coverdell education savings accounts grow tax-free and are not taxed when withdrawn if used for eligible expenses.
Unlike 529 plans, contributions are limited to $2,000 per year per beneficiary. Additionally, funds must be used by the age of 30; otherwise, fees, penalties, and taxes will apply to the growth within the account. The limited contribution potential, strict deadlines, and the rising cost of higher education might make another type of college savings account more beneficial.
Roth IRA
An overlooked option for saving for college is a Roth IRA. Funds in your Roth IRA can be used to pay for college expenses; however, there are limitations. For one, gains withdrawn before the age of 59 ½ will be taxed at ordinary income rates. The IRS negates the 10% early withdrawal penalty, but still imposes taxes on account growth. The funds used toward education must also be in the account for at least five years before you can make a penalty-free withdrawal.
Additionally, contributions to your Roth IRA are limited to the annual limit, which is $7,000 for the 2024 tax year ($8,000 if you are over the age of 50). Moreover, if you are depending on your Roth IRA as a retirement strategy, depleting the funds might not be in your best interest, especially when creating a taxable event.
Other College Saving Options
529 plans, Coverdell education savings accounts, and Roth IRAs are all examples of tax-advantaged options for saving for college. Here are two more options that don’t come with the same tax perks, but might fit your situation:
High-Yield Savings Account
A high-yield savings account is an account that earns interest at a higher rate than a traditional savings account. Rates at the time of this writing range between 3% and 5%. High-yield savings accounts are highly liquid, meaning you can withdraw funds at a moment’s notice. However, you will pay taxes on the interest earned within the account.
If your child or grandchild is attending college in the next few years, opening a high-yield savings account can be a great option compared to investing the funds in the market. There are also no limits on the funds you can hold in a high-yield savings account.
Taxable Brokerage Account
If you are beginning to save for college expenses more than a few years out, you can invest funds in the market through a taxable brokerage account. Like a high-yield savings account, you will pay taxes on any interest, dividends, and realized capital gains each year.
Conclusion
Saving for college can be a great way to take advantage of tax deductions and tax-free growth; however, it’s always recommended to save for retirement before building a college savings fund. There are numerous avenues to borrow money for college, but not when it comes to retirement. If you have questions about college savings options, please contact us.
