Tax-Smart College Savings Strategies for Parents
College is expensive. Data for the 2019–2020 academic year indicates that the average cost of tuition, fees, room, and board was $30,500. The tax law has provisions to help you cover the costs, including Coverdell accounts, Section 529 savings plans, and Section 529 tuition plans.
Contribute to a Coverdell Education Savings Account
You can contribute up to $2,000 per year to the child’s Coverdell Education Savings Account (CESA). If you have several children, you can set up a CESA for each of them. Contributions are non-deductible, but earnings are allowed to accumulate free of any federal income tax. You can then take tax-free withdrawals to pay for the account beneficiary’s post-secondary tuition, fees, books, supplies, and room and board.
Maybe not for you. Your right to contribute is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 if you are unmarried, or between $190,000 and $220,000 if you are a married joint filer.
Contribute to a Section 529 College Savings Plan
Section 529 college savings plans are state-sponsored arrangements named after the section of our beloved Internal Revenue Code that authorizes very favorable treatment under the federal income and gift tax rules. You as the parent of a college-bound child begin by making contributions into a trust fund set up by the state plan that you choose. The money goes into an account designated for the beneficiary whom you specify (your college-bound child). You can then make contributions via a lump-sum pay-in or via installment pay-ins stretching over several years. The plan then invests the money using the investment direction option that you select. When your child reaches college age, you can take federal-income-tax-free withdrawals to pay eligible college expenses, including room and board under most plans. Plans will generally cover expenses at any accredited college or university in the country (not just schools within the state sponsoring the plan). Community colleges qualify as well. In essence, a Section 529 college savings plan account is a tax-advantaged way to build up a college fund for your child.
Don’t Confuse Savings Plans with Prepaid Plans
Don’t mix up Section 529 college savings plans with Section 529 prepaid college tuition plans—which we will give only a brief mention here. Both types of plans are properly called “Section 529 plans” because both are authorized by that section of the Internal Revenue Code. Both receive the same favorable federal tax treatment. But that’s where the resemblance ends. The big distinction is that prepaid tuition plans lock in the cost to attend certain colleges. In other words, the rate of return on a prepaid tuition plan account is promised to match the inflation rate for costs to attend the designated school or schools—nothing more, nothing less. That’s okay if that’s what you really want.
No Kiddie Tax on Section 529 Plan
You don’t have to worry about the kiddie tax if you set up a custodial 529 plan in the child’s name. The 529 plan is an investment plan where the monies remain in the plan. You make contributions with after-tax dollars. When the child takes the money out of the plan for college, he or she does so tax-free when the funds are used to pay for qualified higher education expenses.