We left off talking about 529 Plans last week, but now it’s time to go over another option: Coverdell Education Savings Accounts. This account operates similarly to a 529 plan, and here’s why:
A Coverdell Education Savings Account is a tax-advantaged savings vehicle that lets you contribute up to $2,000 per year for your child's elementary, secondary, or college expenses. You open a Coverdell ESA at a bank or other financial institution. You are the account owner, and your child is the beneficiary, and some institutions may charge a fee for opening and/or maintaining the account.
Okay, now here is how they differ. Unlike the case with a 529 plan, you select the investments you hold in the account. You can choose mutual funds, stocks, bonds, ETFs, and so on. Assets in the account accumulate tax-deferred, similar to a 529 plan. Any earnings in your account are completely tax-free at the federal level and typically at the state level when funds are withdrawn to pay the beneficiary's qualified education expenses. And as with a 529 plan, the earnings portion of any withdrawal that is not used for the beneficiary's qualified education expenses is subject to federal income tax and a 10% penalty,
The biggest drawback of a Coverdell Education Savings Account is that the annual $2,000 contribution limit is quite low, making it hard to amass anything near what might be required for college. However, a Coverdell account might be helpful in combination with other savings strategies.
The only other problem is that not everyone can open an account. There are often some restrictions based on gross income, and it can be challenging to fit into the specific numbers.
Let’s look at the 2022 numbers, to make the total $2,000 contribution, your modified adjusted gross income must be less than $220,000 if you're married filing jointly and less than $110,000 if you're filing singly. A partial contribution is allowed if your income is slightly above these levels. Since this can get a little confusing and could also mean that the amount you are actually able to save is lower and slower than some other means, it’s smart to continue to look at other college savings options until you find one you feel comfortable with.
Another college savings option that offers federal tax advantages but whose primary purpose isn't saving for college is Roth IRA’s. A Roth IRA is a retirement savings vehicle, but some parents have found that it works pretty well as a college savings tool, too. Why is that? Well, with a Roth IRA, once you turn 59, you can withdraw funds for any purpose - college, retirement, home remodeling, what have you - with zero tax implications or penalties. So there's flexibility there.
But what if you're younger than 59? Well, generally, there is a 10% early distribution penalty on the earnings portion of any withdrawal made before age 59. Essentially, Uncle Sam doesn’t want you to start using the money sooner than you are supposed to, but he’ll make an exception for college like any good older family member. That means that if a withdrawal is used to pay a child's college expenses, the 10% penalty is waived. However, the earnings portion of the withdrawal will still be subject to income tax. Because it just couldn’t be THAT easy, could it?
Another advantage of using Roth IRAs as a college funding tool is that retirement accounts, in general, aren't counted as an asset in federal or college financial aid formulas. This means your retirement balances will have zero impact on your child's potential aid award. This can be a huge and unexpected plus. Colleges love to collect money, and if they get a whiff that you might have enough of it, they will likely try to keep financial aid to themselves so that you give them more. A Roth IRA avoids this and allows your child to collect the financial assistance they originally would have been eligible for. However, any withdrawals will count toward your income for financial aid purposes. So in the interest of keeping the greedy claws of your child’s college off of your hard-earned money, you might consider waiting until after January 1 of your child's second year of college to withdraw funds from a Roth.
Also, the maximum amount that can be contributed to a Roth IRA in 2021 is $6,000-or $7,000 if you're age 50 or older, which is higher than a Coverdell Education Savings Account but much lower than a 529 plan. Keep in mind that this limit is for traditional and Roth IRAs combined.
However, not everyone can contribute to a Roth IRA. Your ability to contribute is based on your modified adjusted gross income, kind of like the Coverdell Education Savings Plan situation. In 2022, to make the total contribution, your income must be $129,000 or less as a single filer or $204,000 or less if you file jointly. A partial contribution is allowed for specific income ranges.
Of course, using Roth funds to ship your child off to college means you'll have less available for retirement. That’s not fun, but it’s the price we pay for that extra space in the house. We’ll talk more on that later, though.
Finally, your child could also contribute to his or her own Roth IRA using earnings from a part-time job. And if your child doesn't end up using the funds for college, the money is still available for retirement or other purposes (such as a down payment on a home), as long as Roth IRA distribution rules are followed.
This is another great perk, and I’m not just talking about the idea that your child might actually contribute some money. The fact that any extra money is available for your child after their college experience is a great stress reliever, and a great way to help get them on their feet after they graduate depending on the number of funds left over.
Which Options Are Right for You?
Okay, that was a lot of information, so let’s recap all the options we discussed in a way that might be a little easier (or at least quicker) to read.
Let’s start with who can participate in each plan. As we discussed, 529 plans, along with mutual funds and stocks, are open to anyone, whereas Coverdell Education Savings Accounts and Roth IRAs have income restrictions on who can participate.
Now, let’s talk about contribution limits. In general, 529 plans have very high lifetime contribution limits – typically $350,000 and up. By contrast, Coverdell ESAs have a very low $2,000 annual contribution limit, while Roth IRAS has a moderate annual contribution limit of $6,000, or $7,000 if you are age 50 or older. Meanwhile, mutual funds and stocks have no contribution limit
Moving on, let’s try to explain which options offer you full investment control.
Here’s the simplest answer I can give you: all of them - except 529 plans. But remember, with a college savings plan, you have to choose from among the plan's pre-established investment portfolios. And if you're unhappy with the market performance of the investment portfolios you've chosen, you can change the investment options on your existing balance only twice per year.
Now let’s take a look at which ones offer tax-free earnings since that can make a major difference in the amount you are able to save. This is undoubtedly one of the most important features, so we’ll start with the ones that are tax-free.
If used for the beneficiary’s qualified education expenses, 529 plans and Coverdell ESAs offer 100% tax-free earnings.
With Roth IRAs, it's a bit trickier. Your contributions can always be withdrawn tax-free at any age and for any purpose because they are made with after-tax dollars, but there is a big difference between your earnings and your contributions. Whatever you contribute is safe to withdraw, but the earnings you make on those contributions via interest are subject to different rules. So let’s say you are 59 or older. In that case, the earnings portion of any withdrawal is tax-free. But if you are younger than 59, the earnings portion of any withdrawal is subject to income tax, even if you use the money for college. There is the 10% early distribution penalty that we discussed but, again, this can be waived as long as you are using the money for college. If you use the money for anything else, the penalty still applies. By contrast, with mutual funds and stocks, you are taxed on the earnings every year.
Next up is flexibility. Which options allow you to use the money you've saved for non-educational expenses pretty easily? Well, Roth IRAs are primarily a retirement savings tool, so we know the money can be used for purposes besides college. And, of course, mutual funds and stocks can be used for anything, too. By contrast, both 529 plans and Coverdell ESAs impose an income tax and a 10% federal penalty on the earnings portion of any withdrawal that is not used to pay qualified education expenses,
Finally, which investments aren't counted for purposes of financial aid? In other words, which investment plans will not interfere with the amount of financial aid your child is eligible to receive when they start attending school? That’s easy, it’s Roth IRAs. Roth IRAs aren't counted in either the federal or college financial aid formulas. 529 plans, Coverdell ESAs, mutual funds, and stocks are all counted as assets, provided they are owned by the parent.
Now that we've gone through these options in more detail, it might be helpful to look at them in the context of a hypothetical couple who wants to start a college fund. Another real-world example, but this one is a little more in-depth and, hopefully, a little more helpful than just throwing some numbers your way.
Obviously, there are a lot of options to choose from but, regardless of what you decide, the most important thing you can do is to start saving as early as possible, with whatever amount you can afford. Then, continue to add to it as often as you can. The sooner you start saving, the more time your money will have to potentially grow and the less you or your child may need to borrow down the road. And speaking of down the road, let's look ahead for a minute to the college years.
Paying for college can be a little like a puzzle - there are a lot of pieces that go into it and it can be time-consuming trying to fit them together in the best possible way. The most important part is your savings, which we've just talked about at length. But that's only one piece.
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Until next time...