Those that choose to invest in the education of a family member, friend or acquaintance are investing not only in that individual’s future, but also the future of society. It is an act of generosity, forward-thinking, and love. However, this type of investment can be more complicated than initially thought. Which plan should you choose and how do you decide? Here are some key details about 529 plans and other education savings options to help you decide which plan is appropriate for you and your loved ones.
People invest in a 529 plan for several reasons. Many states offer tax benefits that will continue as the balance of the account grows and the funds are distributed toward education expenses. State-run 529 plans allow you to invest in mutual funds and your earnings can grow tax-deferred. There are two kinds of 529 plans:
- College Savings Plan
- Prepaid Tuition Plan
The college savings plan is the more popular of the two. Contributions to this plan grow tax-free and then when you distribute the funds, they are tax-free as long as it is toward an eligible educational expense.
Depending on what state you live in, you may be afforded a tax deduction or credit for your contributions.
The 529 plan is most beneficial if you begin saving for it early, otherwise you may want to consider a different type of instrument.
There are a few disadvantages that you should be aware of:
- If the contributions are used for anything other than eligible educational expenses you may have to pay a penalty.
- Plans have a limit of only one beneficiary at a time, so if you have multiple children whose education you want to help fund, you may need multiple plans.
- There is no federal tax deduction or credit for your contributions.
Uniform Transfers to Minors (UTMA) and Uniform Gifts to Minors (UGMA)
UTMA and UGMA are custodial accounts that allow an individual to contribute or transfer funds to a minor without having to establish a trust. Both accounts are created under the name of the child but managed by a parent or guardian until the minor reaches the age where the assets can be passed to them (the age varies with state).
UTMA and UGMA contributions are made with after-tax dollars and follow the gifting rules of up to $17,000 annually (for 2023) without being subject to a gift tax ($34,000 for married couples). The first $1,250 earnings from any of the accounts may be tax-free. The next $1,250 of any earnings in excess of the exempt portion may be taxed at the child’s tax rate. Anything thereafter is taxed at the parent’s tax rate. [i]
Difference Between a UTMA and UGMA
An UTMA allows nearly all types of assets as gifts and transfers including:
- Securities (stocks bonds, and mutual funds)
- Bank deposits
- Insurance policies
- Real estate
Whereas an UGMA is limited to just bank deposits, securities, and insurance policies. The UTMA is considered more of an expansion of the UGMA, and most states have adopted the UTMA rules.
A disadvantage of a UTMA and UGMA account is that they are reported as the child’s asset reducing federal aid eligibility at a larger percentage than the 529 plan which is a parental asset.
Traditionally Roth IRA accounts are used as retirement savings instruments, but they can also be used for educational purposes. No tax deduction occurs initially, so your account can experience tax-deferred growth. Earnings withdrawals will be taxed except for the following circumstances:
- The account has been open for at least five years
- Account owner is age 59 ½ or older
- Death of the account owner
- First-time homeowner
However, for qualified educational expenses, the additional 10% penalty could be waived. [ii] Original contributions to a Roth IRA account are allowed to be withdrawn tax-free at any point, because the taxes on it have already been paid.
A disadvantage of a Roth IRA is that you are limited to $6,500 for the year in 2023 ($7,500 if you are 50 or older), and you cannot withdraw any earnings earlier than the eligibility requirements, or you will have to pay taxes and a 10% penalty.
Permanent Life Insurance
For some individuals, permanent life insurance might be a suitable option due to the tax-deferred savings structure. When your child is preparing to enroll in college, you can take a loan out against the cash balance.
Every dollar put toward premiums goes to both the death benefit and a separate cash-value account. The money in the cash-value account will grow tax-deferred, with the potential to generate a three percent to six percent return.
Unlike a 529 plan, life insurance can offer more flexibility. If your child decides not to attend college, you won’t experience the tax burden and penalties of a 529 plan. Another benefit is that life insurance is not included in financial aid calculations.
A disadvantage of permanent life insurance is the costly upfront and recurring fees. It takes a long time for your money to grow enough to exceed the amount paid in premiums, so if you are considering using this method, you have to start when the children are very young.
Coverdell Education Savings Account (ESA)
An ESA is a tax-deferred account that helps families fund educational expenses. Beneficiaries are required to be under the age of 18 at the creation of the account. However, the age restriction may be waived for special needs beneficiaries. The contribution limit is $2,000 per beneficiary annually, though multiple accounts may be set up for a single beneficiary.
ESA funds have to be used by the time the student reaches 30-years old, although the funds may also be used to cover educational expenses for kids between grades K-12 depending on the eligibility of the school.
ESA funds can be used to cover tuition and other qualifying expenses like books, fees, supplies, room and board. [iii]
Disadvantages are that contributors must earn less than $110,000 per year. Contributions are also not tax-deductible and no contributions are allowed once the child turns 18. [iv]
If investing in the future of a loved one is something you want to explore, consider consulting a financial professional to help you work through your options and determine which is appropriate for you and your financial goals.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
Prior to investing in a 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Non-qualified withdrawals may result in federal income tax and a 10% federal tax penalty on earnings. Please consult with your tax advisor before investing.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals 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. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
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