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How Education Savings Accounts Work (When Funds Aren’t Used)

One of the fun things about having young kids in your life is getting to hear about future plans for their lives. One week someone might want to be a veterinarian; the next week, they’re planning on being a firefighter-slash-makeup artist. Only time will tell what path that kid will take, and what kind of educational costs that path will involve. That unpredictability can make education savings accounts seem a little daunting for parents, grandparents and other family members. 

Knowing that a four-year college education at many schools could cost hundreds of thousands of dollars by the time your child is 18, you want to have money saved to cover some or all of those expenses. Both 529 plans and Coverdell education savings accounts help families with that goal, on a tax advantaged basis.

But what if they choose a career path that doesn’t require a college education? Or are they so talented that they receive a full scholarship? Would you be better off investing money somewhere other than in an education savings account, in case that happens? And if you are going to use education savings accounts to plan for a child’s college costs, which is the best fit for an unpredictable future? Your financial planning advisors can fill in the specifics, but here’s a look at some of the things you should consider..

529 Plans

529 plans, named for a section of tax code, are education savings plans that are sponsored by individual states. (Some 529s have residency requirements and/or tax benefits that only apply to residents, but generally you’re free to open a 529 in any state.) Two basic types of 529 plans exist.

Prepaid tuition plans allow parents/grandparents to pay for a child’s future college costs at today’s tuition rates. The cost per credit or per year of college education is locked in at the current rate when the plan is opened, and payments can then be made in installments. The beneficiary can use their prepaid tuition plan to cover tuition at any school that’s eligible under their plan. 

Education savings plans are the more flexible type of 529 plan. The fine print and specific tax benefits differ from state to state. Generally speaking, anyone can open a 529 plan on behalf of an American beneficiary. Even adults can use 529 plans to save for their own education expenses. Anyone can make contributions to the account, and the contributions are not deductible for income tax purposes. In addition, 529 contributions are subject to gift taxes.

A beneficiary can withdraw 529 money tax-free, provided the withdrawals are used to pay for qualified higher education expenses. The Tax Cuts and Jobs Act expanded allowable withdrawal provisions so now beneficiaries may also take up to $10,000 per year out of a 529 plan to pay for tuition at public or private K-12 schools. 

What’s an eligible expense under a 529 plan?

Money from a prepaid tuition plan can only be used for tuition expenses, but 529 education plans can be used to cover a broader range of college costs. Again, there’s some variation from state to state, but money in an education savings plan can generally be used for tuition and fees, room and board (with some restrictions), required books/equipment and special needs services including tutoring. 

What happens if the beneficiary doesn’t use the money?

Say the child you create a 529 plan for establishes a successful career without going to college and doesn’t need any of that money. This is where prepaid tuition plans can backfire. If the beneficiary doesn’t go to college, the plan could be transferred to a family member. Or you may be able to get a refund for the money you contributed over the years, minus fees and without any interest. You end up with less than what you put in and missed the opportunity to earn interest on that money while it was tied up in the tuition plan. 

Unused money in a 529 education savings plan, however, can also be rolled over into a 529 for someone in the beneficiary’s family. The beneficiary can be changed multiple times, so one 529 with a large pool of unspent college funds could theoretically help multiple family members pay their way through school. Or, the beneficiary can empty the account to use the money in whatever way they wish—but will pay a 10% penalty for taking non-qualified withdrawals and be taxed at their normal income tax rate. However, the penalty and income tax is assessed on the growth within the 529 Plan, not the contributions that were made.

Coverdell Education Savings Accounts

Sometimes referred to by their former name, “education IRAs,” Coverdell ESAs were renamed in honor of the senator who championed the legislation that created them. 

Like with many 529 plans, contributions to Coverdell ESAs are not tax-deductible. Also like 529s, beneficiaries can take out money tax-free to pay for qualified education expenses but will be taxed on any portion of a deduction that’s not used for qualified expenses. But there are several key ways ESAs differ from 529 plans. 

First, a beneficiary’s Coverdell ESA can receive no more than $2,000 in total contributions per tax year. Second, there are income limits for contributors. Your modified adjusted gross income must fall below a certain limit for the tax year in order to make contributions to an ESA. Currently, a single filer with a modified adjusted gross income (MAGI) above $110,000 or joint filers with a MAGI above $220,000 are not eligible to contribute to a Coverdell education savings account.

Contributions may only be made while the child is under 18, unless they’re a special needs beneficiary. This type of account can be used to save for K-12 costs (in addition to college costs) without the annual $10,000 cap that 529 plans have. 

Coverdell education savings accounts may be used in conjunction with 529 plans. The contribution limits make this type of account less attractive than a 529 for some families, and high-income families won’t even qualify. It might be most appealing to parents of young children who anticipate having significant secondary school expenses and want a supplemental, tax advantaged savings plan for those costs.

What’s a qualified expense for an ESA?

Per the IRS, beneficiaries of Coverdell accounts can only use that money tax-free on qualified education expenses at a school of any level. Eligible expenses include tuition and mandatory school fees, room and board, required books, equipment including computers and special needs services. K-12 students might also use ESA funds for things like school uniforms, transportation and even extended day programs. 

What if they don’t use the money?

Unless they have special needs, a beneficiary has until age 30 to use their ESA funds for education expenses. After turning 30, they have 30 days to withdraw any unspent money in the account. They pay a 10 percent penalty and are taxed on the growth in the account at their regular tax rate. Or, unspent money in an ESA may be passed to a different family member for their educational expenses. They can transfer the account to another ESA or roll it over into a 529, with their sibling, child, spouse or even an in-law as the beneficiary. 

Which Plan Makes Sense For Your Family?

As you evaluate education savings accounts, a lot of what-ifs come up. What if your child doesn’t end up wanting to go to college? What if you put money in a different investment vehicle instead, to try to get a better return? What if your savings fall short of tuition at the school they end up choosing? 

Sachetta, LLC walks through the education savings process with family after family. Our advisors help clients sort through their options and create the strategies that best meet their specific needs, both now and down the road. We’re here to help you navigate education savings accounts in whatever way you need. Contact us today.

by Jeffrey R. Aron, CFP®, MSFP

As Senior Wealth Manager, Jeffrey R. Aron, CFP®, MSFP manages all aspects of Financial Planning and client services, including the preparation of comprehensive financial plans (retirement, education, cash flow, etc.), insurance and asset allocation recommendations, advanced estate planning strategies and of course, plan implementation.

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