Tax-Smart Ways to Save for CollegeBy Matthew P. Krouse, CFP®, AAMS® | September 28, 2023
September is National College Savings month. Saving for college is a top financial priority for most parents, but it’s easy to overlook one very important detail—the ways that saving for college could impact your taxes. How you save is just as important as the amount you save. It also touches other parts of your financial life, including your retirement planning. Smart college planning begins by backing up and looking at the big picture.
3 Ways to Save for College
Below are the most common ways to save:
- 529 Savings Plans: These are investment accounts that serve as college funds. Money that’s used for qualified education expenses is exempt from federal income taxes—that includes withdrawals for tuition, fees, room and board, supplies, books and more. The account is opened by a parent or guardian who lists the child as the beneficiary. The beneficiary can be changed if they choose not to attend college. You can contribute as much as you want, as long as you stay in accordance with gift tax rules. (More on this shortly.)
- 529 Prepaid Plans: With this type of 529, you purchase tuition credits at a specific school today, at the current price. Your child can then use those funds in the future. If tuition prices go up, and they likely will, they’ll have that lower rate locked in. Residency requirements usually apply. If your child ends up going to another participating school, they can still use those funds. Prepaid 529 plans offer less flexibility when it comes to qualified expenses. They typically only cover tuition and fees.
- Custodial Accounts: These are similar to brokerage accounts. You can open a custodial account on behalf of a minor child. As the adult, you manage all the details—from contributions to investment decisions. Your child then takes over the account when they come of age. They can use the money for whatever they like, including college. There are no contribution limits, and individuals can put in up to $17,000 in 2023 without facing a tax penalty. Whatever you contribute beyond that is applied to your lifetime gift-tax exclusion, which is $12.92 million as of 2023.
Important New Rules for 529 Plans
Beginning in 2024, the SECURE 2.0 Act will allow you to transfer funds from an unused 529 plan to a Roth IRA for the beneficiary. That can give your child a major jump on growing their wealth. Depending on how much you contribute and average annual returns, it could potentially amount to millions of dollars in the long run. Here are some key details to consider:
- The Roth IRA account must be at least 15 years old.
- You can rollover up to $35,000 throughout your lifetime.
- Contributions and earnings from the last five years cannot be rolled over.
- The rollover amount will count toward your annual IRA contribution limits.
How Saving for College Could Affect Your Tax Bill
You want to make sure you’re saving for college in the most tax-efficient way possible. 529 savings plans have unique tax benefits, including tax-free investment earnings. Some 529 plans allow for tax-deductible contributions at the state level, or state tax exemptions on withdrawals. These are important things to think about when saving for college.
The ”Kiddie Tax” may also come into play. This is the tax a minor must pay on unearned income. That includes investment gains, interest and dividends. The first $1,250 is eligible for the standard deduction. The next $1,250 is taxed at the child’s income tax rate, which is likely 10%. Anything beyond $2,500 is taxed at the parent’s regular income tax rate—which could be as high as 37%.
Saving for College and Tax Planning Go Hand in Hand
Saving for college shouldn’t be separate from your long-term financial planning. At Opal Wealth Advisors, we use innovative tax-planning software to model out different scenarios. It allows us to illustrate how your college savings could potentially grow, depending on how you save.
We’re also able to look at these things in conjunction with your retirement plan. This type of integrated planning illustrates our Opal Way approach. It’s a client-centered, holistic form of financial planning that looks at all the moving parts of your financial life. For instance, we can integrate the kiddie tax into your overall tax strategy and plan accordingly so there are no unwanted surprises down the road.
This pairs naturally with our free guide “10 Ways to Reduce the Tax Bite on Your Retirement Income.” Knowing what to expect—and planning ahead—can help you keep more of your hard-earned money. It all comes down to effective long-term tax planning. Schedule a call with us today to get started.
Sources: Experian, Fidelity Investments, Northwestern Mutual, IRS.gov, Charles Schwab, CNBC, Nolo.
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