Are you anxious about rising higher education costs? College can be a valuable experience, but it’s becoming less and less affordable since costs are growing at approximately 6% each year, which is more than twice the inflation rate.

However, with the proper foresight and knowledge, you can utilize different investment vehicles to increase the likelihood that your loved ones will graduate with minimal or no student debt. Some accounts, such as 529 plans, have multiple tax advantages that make it easier to accumulate sizable accounts. Other types of savings plans may offer additional benefits such as protection from market losses, exclusion from financial aid formulas, and more.

529 Plans

529 plans are one of the most common education investment accounts and are administered on a state-by-state basis. Benefits include:

1. Tax advantages

   Funds that are invested in 529 plans grow tax-deferred like a 401(k) plan. The distributions are not taxable, provided that they’re used for qualified educational expenses. This is a broad term, but it includes tuition, books, supplies, student housing, and more. If you don’t use the funds for qualified educational expenses, then you’ll have to pay ordinary taxes and a 10% penalty.

   Every state has different rules for 529 plans. For example, some states like Arkansas allow you to deduct up to $5,000 per year if you file single or $10,000 if you’re married filing jointly. Others like California, tax 529 plan distributions.

2. No set contribution limits

   Unlike Roth IRAs, IRAs, and 401(k)s, there aren’t any set contribution limits. However, states may have their own limits, which can be as high as $529,000 per year! Also, if you contribute more than the annual gift exclusion of $15,000 per beneficiary this could trigger gift taxes. Consult your tax advisor if you have any concerns or questions on this.

3.  Minimal impact on FAFSA

   The Free Application for Federal Student Aid (FAFSA) is used to determine your eligibility for financial aid. Luckily, 529s owned by the dependent student or parent are considered to be parental assets, which minimally impacts your award.

   The first $20,000 held in a 529 plan will fall under the Asset Protection Allowance. The remainder will reduce your beneficiary’s aid by 5.64%. So, you’ll lose just $564 per $10,000 above this threshold, which may be negligible compared to the tax-deferred investment gains.

Coverdell ESAs

Coverdell ESAs are similar to other education investment accounts like 529 plans as they both offer tax-free investment growth for educational expenses. However, Coverdell ESAs differ from 529 plans because they have a low annual contribution limit of $2,000. 

Funds in this investment account must be used before the beneficiary turns 30 or taxes and penalties will apply. The only exception to this rule is if your child qualifies as a special needs beneficiary. Despite these stricter rules, this account has the following advantages:

1. Can be used for all educational expenses

   Coverdells can be used for a wider variety of expenses compared to a 529 plan. For example, you can pay for your child’s private high school tuition with this account. It can also pay for academic tutoring and special needs services.

2. Flexible investment choices

   Many education investment accounts only let you invest in mutual or index funds. With a Coverdell ESA, you can invest in securities offered by the plan provider. These can include individual stocks, bonds, ETFs, and mutual funds.

3. May have no impact on financial aid

   If a child is the owner and beneficiary of the account, then funds won’t impact financial aid awards. The same applies if it’s owned by the beneficiary’s grandparents, a distant family member, or an unrelated party.

UGMA/UTMA

UGMA and UTMAs are essentially trusts that hold assets during your beneficiary’s childhood. These can hold various investments like stocks, bonds, mutual funds, ETFs, and even real estate. The biggest difference between the two is that UGMAs hold just paper assets like stocks or mutual funds, while UTMAs can own real estate.

UGMAs are adopted by all the states, while UTMAs can’t be accessed in others like Vermont and South Carolina. Unlike 529 plans or Coverdell ESAs; they don’t offer substantial tax-advantages. The first $1,050 of earnings grows tax-free, the next $1,050 of earnings is taxed at the child’s low or minimal tax rate, while earnings above $2,100 are taxed at the parent’s tax rate.

Yet, the biggest advantages of these accounts are being able to set up trusts without a lawyer and ensuring the beneficiary can’t access funds prematurely. This can reduce the risk of your child spending recklessly or being taken advantage of by unscrupulous third parties.

Roth IRAs

You might be surprised to see Roth IRAs on this list of education investment accounts. However, Roth IRAs are very versatile accounts since they offer tax-free growth. That is, provided that you’ve had the account for at least 5 years. 

Roth IRAs can be powerful tools for educational planning because you can access your basis or contributions. Unlike 401(k)s or IRAs, your basis won’t be under lock and key for decades.

Unlike Coverdell ESAs, 529 Plans, or other accounts; there are no restrictions for Roth IRA distributions on specific educational expenses. If you’re younger than 59.5, you can distribute $10,000 penalty-free once in your lifetime to pay for higher education expenses.

Once you turn 59.5, then you can withdraw Roth IRA funds without taxes or the 10% penalty! This can make it a powerful retirement and education planning tool, especially if you’re an older parent or grandparent. 

Yet, a Roth IRA has a low annual contribution limit of $6,000 if you’re younger than 50. You can contribute an additional $1,000 per year once you’re older than 50. Keep in mind that Roth IRA account balances don’t impact financial aid, but withdrawals are considered income. In some cases, this can drastically reduce potential financial aid packages.

Cash-Value Whole Life Insurance Policies

While technically not an investment account, well-structured whole life insurance policies deserve a mention due to their many benefits that make them very useful for funding educational expenses:

1. Ease of access

   The cash value in a whole life policy may be used for any purpose - including paying for college or other education-related expenses. You can borrow your cash value tax-free**, and you won't be subject to the age or contribution restrictions or other limits of a Roth IRA.

2. Protection from market losses

   Another benefit that is important to many parents with high-school aged children is that your savings in a cash-value whole life plan are not subject to market volatility like a 529 plan or Coverdell ESA, which becomes more important as you draw closer to the time when you will need these funds to pay for college.

3. Potentially no impact on financial aid

   Funds held in a whole life insurance policy do not count as an asset on the FAFSA and will not impact most financial aid opportunities. However, if your student is applying to a private school, keep in mind that some of these may look at the cash value as an asset, much as they may count the equity in your home (which also does not count on the FAFSA). 

It can be unnerving to see such high tuition rates for private high schools and universities. Public schools are increasing their tuition steadily each year too. Luckily, planning ahead and saving regularly into the right education investment accounts may help give you peace of mind knowing that you’ll be more able to pay for most, if not all of your loved ones’ education expenses, without going deeply into debt.

Understanding the basic benefits of each type of investment or savings account may help you more easily plan for expensive higher education costs.

For individual guidance on which type of plan may be best for your family, please contact our office for a FREE initial strategy session!

** In most states, assuming the plan is properly structured and maintained. You should consult with a tax professional in your state.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2024 Advisor Websites.