In the college savings game, all strategies aren't 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. Ideally, though, you'll want to choose a savings vehicle that offers you the best combination of tax advantages, financial aid benefits—and flexibility—while meeting your overall investment needs.
529 plans
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. That's because 529 plans offer a unique combination of benefits.
There are two types of 529 plans—savings plans and prepaid tuition plans. Though each is governed under Section 529 of the Internal Revenue Code (hence the name "529" plans), savings plans and prepaid tuition plans are very different savings vehicles.
529 savings plans
The more popular type of 529 plan is the savings plan. A 529 savings plan is a tax-advantaged savings vehicle that lets you save money for college and K-12 tuition in an individual investment-type account, similar to a 401(k) plan. Some plans let you enroll directly, while others require you to go through a financial professional.
529 savings plans offer a unique combination of features that no other education savings vehicle can match, including federal and state tax advantages, high contribution limits, unlimited participation and a wide use of funds to name a few. However, 529 savings plans also have a couple of drawbacks, including no guaranteed rate of return and limited investment flexibility.
529 prepaid tuition plans
Prepaid tuition plans are cousins to savings plans—their federal tax treatment is the same, but their operation is very different. A 529 prepaid tuition plan lets you prepay tuition at participating colleges, typically in-state public colleges, at today's prices for use by the beneficiary in the future. Prepaid tuition plans are generally limited to state residents, whereas 529 savings plans are open to residents of any state. Prepaid tuition plans can be run either by states or colleges, though state-run plans are more common.
Instead of choosing an investment portfolio, you purchase an amount of tuition credits or units, subject to plan rules and limits. However, if your child ends up attending a college that doesn't participate in the plan, prepaid plans differ on how much money you'll get back. Also, some prepaid plans have been forced to reduce benefits after enrollment due to investment returns that have not kept pace with the plan's offered benefits.
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 most neighborhood 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.
The bonds are backed by the full faith and credit of the federal government, so they are a relatively safe investment. 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.
Roth IRAs
Though technically not a college savings account, some parents use Roth Individual Retirement Accounts (IRAs) to save and pay for college. 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.
Financial aid impact
Your college saving decisions can impact the financial aid process. Come financial aid time, your family's income and assets are run through a formula at both the federal level and the college (institutional) level to determine how much money your family should be expected to contribute to college costs before you receive any financial aid. This number is referred to as your expected family contribution, or EFC. Your income is by far the most important factor, but your assets count too.
There are multiple options to consider in your college savings plans, and these are only a few with high-level overviews. As always, we encourage you to speak with a financial professional like those with Busey Wealth Management to discuss your options in-depth. To learn more about our comprehensive services, visit busey.com/wealth-management.
This is not intended to provide legal, tax or accounting advice. Any statement contained in this communication concerning U.S. tax matters is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties imposed on the relevant taxpayer. Clients should obtain their own independent tax advice based on their particular circumstances.
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
This presentation is for general information purposes only. It does not take into account the particular investment objectives, restrictions, tax and financial situation or other needs of any specific client.
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