According to a recent study published by the Federal Reserve Bank of San Francisco, researchers found that over a lifetime, the average college graduate will earn at least $800,000 more than the average high school graduate—even after taking into consideration the cost of college tuition and the four years of lost wages it entails.
That said, however, the need to set money aside for their child’s education often weighs heavily on parents. Fortunately, there are savings plans available to help parents save money as well as provide certain tax benefits. The most popular college savings program is the Qualified Tuition Program (QTP), also known as a 529 plan, which are often the best choice for many families.
In addition to these savings plans, every state now has a program allowing people to prepay for future higher education, with tax relief. With this type of plan, one is essentially buying future education at today’s costs, by buying education credits or certificates from the state or directly from a school. This type of program tends to limit the student’s choice to only participating schools within the state; however, private colleges and universities often offer this type of arrangement.
Under both programs there are two key parties: the Designated Beneficiary (the student-to-be) and the Account Owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program. There are no income limits on who may be an account owner. There’s only one designated beneficiary per account. Thus, a parent with three college-bound children might set up three accounts. Some state programs do not allow the same person to be both beneficiary and account owner.
Federal Tax Rules for Qualified Tuition Programs
Contributions made by an account owner or other contributor are not tax deductible for federal income tax purposes, but earnings on contributions do grow tax-free while in the program. Distributions from the fund are tax-free to the extent used for qualified higher education purposes.
Distributions used for a purpose other than qualified education is taxable to the individual receiving the distribution to the extent of the portion which represents earnings. In addition, a 10 percent penalty will be imposed on the taxable portion of the distribution.
The account owner may change the beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them. Thus they qualify for the up-to-$14,000 annual gift tax exclusion in 2016. One contributing more than $14,000 may elect to treat the gift as made in equal installments over the year of the gift and the following four years so that up to $70,000 can be given tax-free in the first year.
However, a rollover from one beneficiary to another in a younger generation is treated as a gift from the first beneficiary, an odd result for an act the “giver” may have had nothing to do with.
Funds in the account at the designated beneficiary’s death are included in the beneficiary’s estate, another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner’s death are not included in the owner’s estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $14,000. For example, if the account owner made the election for a gift of $70,000 in 2016, a part of that gift is included in the estate if he or she dies within five years.
A Qualified Tuition Program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $70,000 avoids gift tax and estate tax by living five years after the gift, yet has the power to change the beneficiary.
Taxpayer’s may use multiple tax benefit programs in the same year, although generally expenses cannot be used for more than one program. Unlike certain other tax-favored higher education programs, such as the American Opportunity Credit (formerly the Hope Credit) and Lifetime Learning Credit, federal tax law doesn’t limit the benefit to tuition, but can also extend it to room, board and books (individual state programs could be narrower). A distribution may be tax-free even though the student is claiming an American Opportunity Credit or Lifetime Learning Credit, or tax-free treatment for a Coverdell ESA distribution, provided the programs aren’t covering the same specific expenses.
State Tax Provisions
State tax rules are all over the map. Some reflect the federal rules; some reflect quite different rules. Nebraska and Missouri offer a tax deduction for contributions to a state-qualified 529 plan. Nebraska allows a deduction of $10,000 ($5,000 for married filing separately) while Missouri allows a deduction of up to $16,000 for married filing joint returns ($8,000 for singles). For specifics comparisons of states’ programs, see http://plans.collegesavings.org/planComparisonState.aspx.
In summary, you can see there are complexities in using the tax favored savings plans, prepayment plans and using available tax credits where you will mostly likely benefit from some professional guidance. However, the most important thing you can do is start saving when your child is young. The sooner you begin saving, the less money you will have to put away each year. For example, suppose you have one child, age 6 months and you estimate that you’ll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you’ll need to save $3,500 per year for 18 years (assuming an after-tax return of 7 percent). On the other hand, if you put of saving until your son is 6 years old, you’ll have to save almost double that amount every year for 12 years.