College is expensive! But studies show it pays off. Based on 2015 data, median earnings for full-time workers were 84% higher for females age 25 to 34 and 75% higher for males with at least a bachelor’s degree than for high school graduates.1
While many individuals turn to student loans to foot the bill for college, graduating with the burden of student loan debt can erode the benefits of a higher income for years – as well as hinder achievement of other financial goals such as buying a house and saving for retirement. If you still have time to save, there are various tax-qualified savings options you can use to help pay for higher education.
Coverdell Education Savings Account (ESA)
ESAs are IRA-like accounts designed to help families save for education expenses. ESAs can be used for elementary and secondary expenses, as well as college expenses. Anyone may contribute to an ESA on behalf of a child if they meet certain income limits. Contributors may put up to $2,000 per year into each child’s ESA and may contribute for multiple children each year. Contributions cannot be made after a child reaches age 18, unless the child has special needs. Although contributions are not tax-deductible, distributions taken to pay for qualified education expenses are tax-free, including investment earnings. The earnings portion of a distribution that is not used to pay qualified education expenses must be included in the student’s taxable income and is subject to an additional 10% excise tax.
If there are any unused funds after the child turns age 30 (and the child does not have special needs), the funds must be distributed within 30 days or transferred to an ESA for an eligible family member.
529 Plan (also called Qualified Tuition Program)
Originally designed to help pay higher education expenses, 529 plans may now also be used tax-free to pay for up to $10,000 of elementary or secondary education expenses. There are two types of 529 plans:
- A pre-paid tuition plan offered by an eligible educational institution, and
- A college savings plan, which is an individual account plan that grows tax-deferred based on the contributions made and the investments held by the plan
Plan features may vary greatly by the state or institution offering the plan. Many people engage a financial professional to assist with researching their options and establishing a 529 plan account.
A 529 plan account is typically opened for a child, but anyone over age 18 can open an account for their own education. There is no federal income or age restriction for contributing to a 529 plan. And, although some 529 plans may set minimum or maximum contribution amounts, there is no federal limit on contributions, other than the requirement that no more than necessary to pay qualified education expenses may be contributed. As with ESAs, 529 plan contributions are made with after-tax dollars, so there is no federal income tax deduction available. 529 plan earnings grow tax-deferred and may be tax-free if distributions are taken to pay for qualified education expenses. If a distribution is not used to pay qualified education expenses, the earnings portion of the distribution is taxable and subject to a 10% excise tax.
IRAs
Although IRAs were not designed as an education savings vehicle, for some families they provide a pool of assets that can be tapped to help pay college expenses – ideally without jeopardizing the IRA owner’s retirement savings goals. Unlike workplace retirement plans, IRA assets may be accessed at any time.
Traditional IRAs
Traditional IRA distributions are generally taxable to the IRA owner in the year the distribution is taken. If the IRA owner is younger than 59½ at the time of distribution, the taxable distribution will also be subject to a 10% early distribution tax. Distributions are taken to pay higher-education expenses, however, there are exceptions to the 10% additional tax. You can take a distribution from your IRA before age 59½ and not pay the 10% additional tax if you paid qualified education expenses for yourself, your spouse, or your or your spouse's child or grandchild for that year.
Roth IRAs
Roth IRAs can be useful for paying education expenses because the rules allow you to take all your non-taxable dollars out of the Roth IRA first, even if you don’t meet the requirements for a “qualified” distribution. Since Roth IRA contributions are made with after-tax dollars, you can take any number of distributions up to the amount you have contributed, at any age and for any reason, tax-free. Some families prefer a Roth IRA for education savings over an ESA or 529 accounts because there are no penalties if the assets are not needed for education expenses. The assets simply remain in the Roth IRA and can continue growing for the Roth IRA owner’s retirement.
Other Considerations
Although plan features, investment options, and applicable fees are all important considerations in evaluating which education savings method might be best for your family, other factors may affect where you decide to save. For example, for financial aid purposes, ESAs and 529 plan accounts are considered parental assets in most cases. This means the value of these accounts may be taken into account in determining financial aid, whereas IRAs are not figured into the analysis. A financial planner or investment advisor may be best suited to help you weigh all the factors to find the right education savings option for your financial situation.
For More Information
If you want more information on education savings vehicles, see IRS Publication 970, Tax Benefits for Education.
If you have questions about traditional or Roth IRAs, please contact the Mainstar Trust team at 1-800-521-9897 or customerservice@mainstartrust.com.
1 CollegeBoard, Trends in Higher Education: Education Pays 2016, https://trends.collegeboard.org/sites/default/files/education-pays-2016-full-report.pdf