What K-12 Parents Need To Know About Saving For College

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DENVER – SEPTEMBER 08: Second graders watch as President Obama delivers a back-to-school address to … [+] school children on September 8, 2009 in Denver, Colorado. (Photo by John Moore/Getty Images)

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The amount of child tax credits parents will be receiving just went up! 

The American Rescue Plan, signed into law by President Joe Biden recently, increases the annual benefit per child 17 and younger to $3,000 from $2,000 for 2021. It also provides most families the opportunity to receive an additional $600 benefit for kids under the age of 6 for the 2021 tax season. And, if you have a baby in 2021 and meet the income limits, your newborn born in the United States also would qualify for this benefit and would receive a child tax credit payment of up to $3,600. 

Here’s what you need to know:

  • Payments to millions of qualifying American families with children could receive payments as early as this summer from the enhanced child tax credit.
  •  The amount of the monthly tax credit payments depends on your child’s age: if under 6, up to $300 a month; for youngsters 6 to 17, you can expect up to $250 a month. The money will be paid through the end of this year and any remaining amounts can be claimed when parents file their 2021 income taxes in 2022.

How can you make the most of this money? With college costs soaring, it’s a good idea to sock away the money into a college savings plan. For a child who is currently a toddler, the estimated cost of a college education will be $244,667 to attend an in-state, public college or university and $553,064 for a private school!  As a parent of three, and a longtime financial advisor, I’m always on the lookout for the best ways to save for future education. Here is what I have found:

  • A 529 College Savings Plan—Like a retirement plan, the main advantage of a 529 plan is that the money grows in your account free of federal income tax. The money must be used for qualified higher education expenses, such as tuition, books and room and board but up to $10,000 a year can be used for tuition for K-12 education. 
  • Pros and cons—If the beneficiary doesn’t want to go to college, you can change the beneficiary to a child who does, or even to yourself and there are no age or income limits. Other family members can contribute (although there are limits on how much without paying gift taxes), and contributions and earnings grow tax free. There are no taxes on withdrawals used for qualified education expenses and you can switch beneficiaries to pay off college loans, plus there are estate planning benefits. BUT earnings spent on other than qualified education expenses are subject to income tax and 10% penalty.
  • In addition—More than 30 states offer a tax credit or deduction for 529 plan contributions, including Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana and Pennsylvania.

Another way to save for college is through a Coverdell ESA, which is similar to a 529 savings plan in that contributions grow tax-deferred and are not taxed when used to pay for higher education or qualified K-12 expenses. These include tuition and fees, books, supplies and equipment, academic tutoring and special needs services for beneficiaries with a disability.

 Unlike 529 plans, however, Coverdell ESAs offer self-directed investment options: families can invest Coverdell funds in any of the securities offered by the plan, including stocks and bonds, exchange-traded funds, mutual funds and real estate investments.

But only individuals earning less than $110,000 and married couples earning less than $220,00 annually may contribute to a Coverdell plan and the $2,000 per year contribution limit is reduced as incomes climb near the upper income bracket. Families can make contributions until the beneficiary reaches age 18.

There are some pretty strict rules: If the funds aren’t spent by the time the beneficiary turns 30, they will be distributed and the beneficiary will be taxed. The $2,000 annual contribution limit applies to all sources—including contributions by grandparents—for a single beneficiary. Contributions must end at the time a beneficiary turns 18, even if he or she is still in high school. And the strict income guidelines are ever changing so it’s best to consult a financial advisor before contributing to a Coverdell.

Can you have both a 529 account and a Coverdell ESA account? Yes, so long as the combined annual contribution is less than the annual gift tax exclusion amount. Until recently, only the Coverdell allowed the funds to be used for K-12 education expenses. . But the Tax Cuts and Jobs Act in 2017 expanded the 529 program to include up to $10,000 per year in K-12 tuition. In addition, you may roll over a Coverdell account into a 529. 

Did you know you can also use your Roth IRA account to save for college? There is no income tax deduction on contributions you make to a Roth but your contributions and earnings grow tax free. If you don’t want to use it all for your child’s education, the balance can remain in your Roth for your retirement. You must have held the Roth for at least five years before you can tap it for education expenses and, even if you have not yet reached the withdrawal age of 59 ½, you may still be able to take funds out of your Roth IRA tax and penalty free for qualified education expenses. Another advantage: Roth monies are not included as an asset on the FAFSA (college financial aid application form), which means the value of your Roth IRA won’t hurt your child’s financial aid eligibility. The annual contribution is low, however, compared with what you can contribute each year to a 529 plan.

LYNCHBURG, VA – MAY 19: Liberty University graduates celebrate after the school’s 34th commencement … [+] ceremony, the first without Rev. Jerry Falwell, May 19, 2007 in Lynchburg University. Funeral services for Falwell, founder of Liberty University and Thomas Road Baptist Church, will be held May 22 at Thomas Road Baptist Church. (Photo by Mario Tama/Getty Images)

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There are some things to consider regarding how a 529 plan could affect your child’s eligibility for financial aid. Plans owned by a parent or dependent student generally receive favorable treatment on the Free Application for Federal Student Aid (FAFSA). In most cases, your 529 plan will have a minimal effect on the amount of aid you receive and will end up helping you more than hurting you. However, 529 plans owned by anyone else, including a grandparent, could affect a student’s eligibility for need-based federal financial aid. Under recently modified rules, plan holders can withdraw a lifetime maximum of $10,000 from their 529 accounts, federally tax-free, to help pay off qualified education loans. 

Yet there are some important ways that grandparents can help without affecting a beneficiary’s eligibility for financial aid. First, any contributions grandparents make to a 529 account already set up by the student’s parents will have no impact on student financial aid initially. If grandparents have set up their own account for the child, they can transfer the ownership to the parents just before the student starts college, if the account allows such a transfer. There also is a special tax-code exemption allowing grandparents to help pay for college tuition without that money being subject to gift tax. The exclusion, called the Gift Tax Education Exclusion for Tuition, allows money that’s gifted to a friend or family member to pay for college tuition to be free of the federal gift tax. Under the Internal Revenue Code, you can pay unlimited amounts for someone’s tuition and not be taxed. The IRS makes this exclusion in the case of financial gifts used for tuition payments. Tuition payments should be made directly to the student’s school, never to the student, to fulfill the gift tax educational exclusion requirement.

* Prior to investing in a 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.

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