Kids just returned to school and parents everywhere rejoiced. The kick off to the school year presents a good opportunity to plan for future college expenses. What’s the best way to support your loved ones’ future education?
Best Overall Option: 529 Education Savings Plan
529 Education Savings Plans are state sponsored plans that give individuals a tax advantaged way to save for college. 529 plan accounts allow you to invest and grow your savings tax free. Distributions from a 529 plan are tax free so long as the distributions are used for qualified higher education expenses.
529 plans have no income limitations on who can contribute and no annual limits on how much you can contribute (although some states cap the overall amount you can contribute at a very high number). Contributions are considered a gift so amounts in excess of your federal annual gift tax exclusion amount ($16K in 2022) will count against your lifetime gift and estate tax exemptions.
Each state chooses its own menu of investment options, generally a few ETFs or mutual funds including some target date options.In Washington State savers are given a selection of 7 different static portfolios based on risk tolerance. Those portfolios are made up of various Vanguard and Schwab stock and bond index funds. There are also year of enrollment portfolios that work like target date retirement plans.
You can generally choose any state’s 529 plan regardless of where you live. Many states offer tax benefits for contributions to a 529 plan for residents. This is not a benefit to residents of Washington State. For a state like Idaho, contributions to Idaho’s plan of up to $6K annually per individual ($12K per married couple filing jointly) are deductible from your Idaho taxable income.
The tax free investment growth and unlimited contribution limit make the 529 education savings plan the best option for most savers.
Best Option for Active Investors: Coverdell Education Savings Account (ESA)
A Coverdell ESA is a trust or custodial account set up in the United States solely for paying qualified education expenses. Like the 529 education savings plan, earnings inside an ESA grow tax free and distributions are tax free as long as they go towards qualifying educational expenses.
The primary advantage of a Coverdell account vs the more common 529 savings plan is the investment options available to a Coverdell account. Coverdell accounts can invest in individual stocks and bonds and have very few restrictions on investment options. These accounts can even invest in assets like real estate and crypto. 529 plans on the other hand are limited to a narrow range of funds chosen by the state sponsoring the plan. The difference between the accounts is similar to the difference between a traditional IRA (with nearly limitless investment options) and a 401K plan (where investment options are limited to those chosen by your employer).
Limitations and Drawbacks of Coverdell ESAs
- Contributions are limited to $2K per beneficiary per year.
- Age Limit- No contributions allowed once a beneficiary hits age 18
- Required withdrawal age- Balance must be fully withdrawn (or transferred to another family member) by the time the beneficiary turns 30
- There is an income limit for those contributing to an ESA (but there is a workaround)
A phase out amount for contributions begins at a 2022 modified adjusted gross income level of $95K for individuals and $190K for married couples filing jointly. No contributions are allowed for individuals making over $110K or married couples filing jointly making over $220K.
However, there is a backdoor way for higher earning parents to fund a Coverdell account. There is no earned income needed to contribute to a Coverdell ESA so a child can contribute to their own account. Parents can give their child the $2K needed to make their own Coverdell contribution (by setting up a UTMA account). The parent can then transfer that money from their child’s UTMA account to the Coverdell account. By following those steps parents essentially make a backdoor contribution to their Child’s ESA.
Washington State’s Guaranteed Education Tuition (GET) Program
GET is Washington State’s prepaid tuition plan. GET allows you to save for future tuition at today’s current price. To invest in the plan, GET account holders buy units equal to 1/100th of the undergraduate tuition rate at the State’s most expensive public university. Thus 100 units will pay for one years tuition at any public university in the state. A student can have up to a maximum of 800 units purchased on their behalf. The highest annual tuition rate in the state for 2022-23 is $11,663, thus the current unit value is $116.63.
To participate in Washington’s plan, either you or the student must be residents of the state at the time of enrollment. The enrollment period is between November 1 – May 31 with year round enrollment for newborns.
Traditionally, units have traded at a premium to the current unit rate value. For the first time in program history, last year’s unit cost was equal to the payout value. The 2022-23 unit price will be set on September 14th. The WA529 Committee (GET’s governing committee) sets the unit purchase price with the input of an actuarial formula that takes into account estimated future tuition, projected inflation and investment returns, and administrative costs.
Historically most college savers would be better off investing in a 529 plan rather than utilizing a prepaid tuition plan. The stock market has handily outpaced inflation for most of history, even with the eye popping increase in tuition in recent years. Additionally, with a prepaid plan you become a creditor of your state and suddenly things like the funded status of the plan become a consideration.
However, for those worried about investment returns or continued tuition hikes, the prepaid plan might be an attractive option.
If you want to discuss your savings strategy and financial situation, schedule a complimentary call today.
Scott Caufield, CFA, CPA