Like many Tennessee residents, you may have found yourself doing a bit of shopping last weekend. Tennessee's annual "Sales Tax Holiday" is a great time to load up on clothes, school supplies, and other necessities for the kids and grandkids. This annual event held during the last weekend in July signals the end of Summer vacation and the beginning of another year of lectures, lunch rooms, and late nights in the library for kids, teens and young adults. For those of you with older children it also means that you may have your first experience of "empty nest syndrome" as your high school graduates head off to college for the first time - we sincerely hope that you have done a good job planning for this day by creating a college funding plan. For those with younger children, now may be a great chance to consider how you will fund your son or daughter's college experience. For those with time left to save, you may be eligible to take advantage of your own tax holiday every day of the year by using tax advantaged college savings plan.
The US Federal Tax Code allows for several types of accounts that are tax advantaged to encourage parents to save for their child's college education. Here we have highlighted some of the key elements of each of the most common savings vehicles available to American no matter your state of residence.
1) Roth IRA’s –Roth IRA’s are well known as a tax-free retirement savings vehicle, but many are less aware of their college planning benefits. Amounts up to what one has contributed to a Roth IRA can be withdrawn from a Roth IRA for qualified expenses. Any earnings, on the other hand, will incur taxes if withdrawn prior to age 59.5 or 5 years after starting a Roth IRA, whichever is later. In addition, Roth IRA’s are not counted towards financial aid and grant eligibility as are other forms of college savings. Nearly the entire universe of investment options is available within Roth IRA’s excluding some complex products and collectibles. The downside is that direct contributions to Roth IRA’s for higher earners (families with taxable income above $196,000) may not be allowed, although we have found ways around this for some families. Contributions are capped at $5,500 per year with an additional $1,000 catch up for those over age 50. As a rule of thumb, I would suggest maximizing Roth IRA contributions first before considering other savings options. Junior could always receive scholarships and not need the money or self-fund his education, but the majority of us will want to retire someday which makes retirement savings much more of a necessity.
2) 529 Plans –These are one of the most well known college savings vehicles with 48 states and the District of Columbia offering state sponsored plans. They are typically invested in mutual funds and offer tax-deferred growth of earnings and tax-free withdrawals for qualifying college related expenses. (tuition, housing, books, etc.) In addition, several states offer additional tax benefits for in-state residents that utilize the state sponsored plan. One of the potential drawbacks to these plans is that withdrawals used for non-qualified education expenses are subject to a 10% penalty. One caveat to the penalty is for withdrawals of up to the amount in scholarships received. The custodian (usually a parent or grandparent) can change the beneficiary (the intended recipient and current or future student) at any time and maintains control of funds even though they are not counted as part of the custodians estate, making 529 Plans an effective estate planning tool as well. There are no income limitations for contributions and contributions of up to $14,000 per year per beneficiary are available with a 5-year $70,000 lump sum contribution available to those that haven’t made prior year gifts.
3) Coverdell ESA’s (Education Savings Accounts) – These offer the same tax-deferral and tax-free withdrawal of earnings that are associated with 529 Plans but with slightly more flexibility. They can be invested in a broader array of choices besides strictly mutual funds and also can be used for elementary, secondary school, and college expenses. Contributions are much more limited, however, as families earning over $220,000 are not eligible and contributions are limited to $2000 per year per beneficiary. Since Coverdell funds are typically earmarked for private K-12 expenditures, the limitations and shorter time period for growth typically outweigh their benefits.
4) Uniform Trust for Minors Account (UTMA) - UTMA accounts were much more popular before Congress limited some of the tax benefits in 1986. These accounts are established as gifts of cash or securities to a minor and are subject to current gift limits of $14,000 per year. As it stands, the first $2,000 of investment income from these types of accounts get special tax treatment. The first $1000 of income is tax-free with the next subject to the child tax rate of 10%. Any investment income above the $2000 threshold will be taxed at the parent’s capital gains or ordinary income rate. The major potential drawback is that once the minor reaches the age of majority (age 18 in most states), assets in UTMA accounts become fully accessible to them. These funds could then be used for a flashy new car or a lavish vacation around the world, instead of a higher education as had been intended.
5) Taxable Investment Accounts –These offer the most flexibility as there are no contribution limits or investment restrictions and funds can be used for any purpose. The primary focus with this approach should be minimizing taxation for the account holder (usually the parent or relative of the future student). Concentrating on tax-advantaged investments like tax-free municipal bonds and funds, exchange traded funds or lower turnover mutual funds, and non-dividend paying stocks often makes the most sense in attaining a satisfactory after-tax return with this strategy. Generally speaking, this is often the best way to save for K-12 expenses given the limitations of Coverdell ESA’s.
While our politicians have discussed changing the benefits associated with various college planning strategies, as of today there is no pending legislation on the books to alter the tax benefits of college savings plans. Working with a financial professional knowledgeable in this area can help you balance this and your other priorities to find the right approach for your needs.
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