You most likely have heard the following quote most often attributed to Benjamin Franklin: “Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes.” So far, Franklin’s quote has proven to be true.
I am sure we all could contribute a few more additional certainties in life. In today’s blog, we’ll consider an additional certainty: The ever-increasing costs of education. So how can we plan for these? Thankfully, the statutes give us many ways to plan for these expenses and save on taxes.
It Starts with a Goal
To decide on the appropriate account type, you need to first decide how you foresee using the funds. You also need to determine the amount of flexibility you want. In general, the more flexibility you desire, the less tax-advantages you receive. Below are some account types, common uses, advantages and disadvantages:
- Uniform Transfer to Minors Act (UTMA) custodial account
- Common uses: Kid’s birthday funds, wedding, car, education
- Advantages: No restrictions on uses; generally taxed at child’s tax rate; no limit on contribution of funds; potential capital growth depending on investments used
- Disadvantages: Restricted use for child’s benefit; beneficiary (minor) generally cannot be changed; “kiddie tax” rules can apply; child receives full control of funds at adulthood (age 18 or 21 depending on state laws)
- Coverdell Savings Account (ESA)
- Common uses: K-12 and college expenses
- Advantages: Tax-free withdrawals of funds used for qualified education expenses; potential capital growth depending upon investments used
- Disadvantages: $2,000 per beneficiary contribution limit; Income restrictions for contributors; less flexibility in changing the beneficiary to another family member; non-qualified expense earnings taxed at federal income tax rates plus a 10% penalty tax
- 529 Plan
- Common uses: K-12 private tuition expenses; qualified higher education expenses
- Advantages: Tax-free withdrawals for qualified higher education expenses as well as K-12 private tuition; no income restrictions for contributors; extremely high contribution limits; potential capital growth depending upon investments used; ability to change the beneficiary to another family member; account owner remains in control
- Disadvantages: Non-qualified expense earnings taxed at federal income tax rates plus a 10% penalty tax
A Tax Planning Strategy
If you live in a state where you pay income tax and also pay private tuition, the following strategy could help reduce your state income tax:
- Open a 529 for each child using your home state’s plan. (For Mississippi’s 529 plan, click here.)
- Contribute to each account for private K4-12 tuition due up to limits. (Currently, the max deduction in Mississippi is $10,000 for single tax filers and $20,000 for joint filers.)
- Leave the funds in the account for the required number of days (For Mississippi, it’s currently 10 calendar days).
- Request a withdrawal to pay for K-12 private tuition expenses (does not include registration, technology or supply fees…only tuition). The max tax-free distribution amount is currently $10,000 per beneficiary. (Click here for FAQs for the Mississippi 529 plan called “MACS.”)
If you implement this strategy each year, you could benefit significantly over time from a tax savings standpoint. We do not recommend implementing this strategy without working alongside your financial planner and tax professional.
A Financial Planning Strategy
As financial planners, we strongly believe in assigning goals to each bucket of funds. That said, opening additional 529 plans for each child can make great sense. Having 529s earmarked for college and others for private K-12 tuition can be quite helpful in achieving your goals.
And let’s answer the common question: What if my child receives scholarships in excess of what we have saved? Well first of all, that’s a great problem to have! Here are some thoughts:
- Most children who receive significant scholarships continue their education beyond their bachelor’s degree. Excess 529 funds can be used for those additional expenses (master’s, law school, medical school, etc.).
- You can change the beneficiary of those funds to another child or family member.
- You can withdraw any remaining funds. You’ll receive any contributions (basis) tax-free, but you’ll pay ordinary income tax and a 10% penalty on non-qualified withdrawals.
In summary, each type of account has its place. You just need to first decide on your primary goals. If you have questions, please do not hesitate to reach out to us. Education planning is a significant part of how we help our clients.
*For financial planning clients of Rivertree Financial Planning: Please contact us as soon as possible if you have had any changes in circumstances, objectives, goals or risk tolerance.
**Please check with each State’s 529 plan for specific rules and guidance before implementing any of the strategies discussed. This article is simply meant for informational purposes only and is not to be viewed as tax guidance or advice.