Paying for college can be one of the largest expenses associated with raising a child, so it’s great to be able to start savings as you go.
One of my favorite ways to save for college is 529 college savings plan. Some states will give you a deduction on your state income taxes for contributions into your state’s plan, and the growth that you get in the 529 is tax-free as long as it’s used for qualifying college expenses, or for private school tuition for k-12 school (currently capped at $10,000 per child per year).
The definition of a qualifying expense is pretty broad. Some common expenses that you can’t use a 529 for are airfare to and from school, getting them a new car, and paying for social activities like fraternities, sororities, study abroad travel, and club dues.
Unless you are planning to front-load your 529, it usually doesn’t make as much sense to use for k-12 school vs college because the REAL benefit of a 529 is to get the tax-free growth.
Now David, what do you mean by front loading a 529? I’m glad you asked! Section 529 of the tax code allows you to spread out a contribution into a 529 over a 5 year period. Why does this matter? Well currently you can only gift $17,000 per person per year before having to file a gift tax return. If you’re a married couple, that means you have $34,000 per person per year. So normally you could only contribute $34,000 per child per year. BUT, if you front load you could contribute up to $170,000 as a married couple. This doesn’t make sense for everyone, but that’s a lot that can be getting tax-free growth!
But what if my kid doesn’t go to college or gets a scholarship? First, you can change the beneficiary of a 529 account pretty easily. You can switch it from one of your kids to another, you can use the funds yourself, you can let it keep growing for a future grandchild down the road, switch to another family member, or just let it sit and grow. There is no requirement for you to take that money out.
If you end up taking the money out and don’t have qualified education expenses you’ll probably owe some taxes. The amount you put in via contributions comes back our federal income tax free. Since you didn’t get any federal tax benefits for the contributions, they don’t penalize you on the way out. BUT, the growth is subject to originally income tax when you take the money out. In addition to the ordinary income, the growth is also subject to a 10% penalty. If the beneficiary got a scholarship, the 10% penalty will not apply to the amount of the scholarship, but you’ll still owe income taxes. You now can potentially convert some of a 529 into a ROTH IRA so the beneficiary can still potentially access that growth tax-free!
I typically suggest using 529 savings plans while the kids are younger so you have more time for tax-free growth. Once the kids are in high school, it starts to make more sense to utilize a regular brokerage account or savings account that can be used for anything in case its not needed for school since there is less time for that money to grow tax-free. Keep in mind, a 529 doesn’t have to be the only thing used to pay for college. You can use current income, other investments, student loans or scholarships to help compliment the 529!
The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.