How do you start saving for college?

Starting to save for college is crucial in preparing for your child’s future education expenses. But how to begin?

Estimating total expenses, setting clear savings goals, and creating a budget are reasonable first steps. However, you should not neglect tax-advantaged strategies to help each dollar saved go farther.

Where you put the money makes a difference.

For example, college savings plans, such as 529 plans, remain popular. These plans can offer tax benefits, such as tax-deferred growth and tax-free withdrawals for qualified educational expenses. They can also provide flexible contributions and may have no income restrictions for account holders, making them accessible to anyone willing to save for a child’s education.

Additionally, many states offer additional tax incentives for contributions to their specific 529 plans, and account owners retain control over the funds, allowing for beneficiary changes or alternative educational expenses.

What is a 529 plan?

A 529 Plan, legally known as a “Qualified Tuition Plan,” is an investment account that encourages saving for future education costs. Authorized by Section 529 of the federal tax code and sponsored by individual states, state agencies, or educational institutions, this plan allows you to defer paying taxes on the money in the account as it grows. Furthermore, you can generally withdraw the money tax-free as long as you use it for qualified educational expenses, as defined by the IRS.

There are two types of 529 plans: prepaid tuition plans and education savings plans.

Both types are only sometimes available in some states. However, all fifty states and the District of Columbia sponsor at least one type of 529 plan.

The specifics of 529 prepaid tuition plans vary from state to state, and there are also prepaid tuition plans, such as in Massachusetts, that are not 529 plans. Still, the principle is broadly the same: contributing to a 529 prepaid tuition plan allows you to lock in future tuition at current rates, thus avoiding rising costs and inflation.

Savings plans are the more common type of 529 plan. They can offer more options compared to prepaid tuition plans. Under a 529 education savings plan, qualified expenses include tuition, fees, room and board, and related costs.

Again, specifics differ state-by-state, but withdrawals from a savings plan are typically applicable at any college or university—even some outside the U.S.

What are the 2023 changes to 529?

The ‘SECURE Act 2.0,’ passed in December of 2022, significantly changed federal law concerning 529 plans. Set to go into effect in 2024; this new rule could have significant implications for nearly 16 million people nationwide who have funded 529 plans.

In the past, 529 plans came with a notable drawback: you could only receive tax benefits if you used your withdrawal for a qualified educational purpose. That meant that if college plans changed, you could only access unused funds at the cost of a tax penalty of up to 10%.

This lack of flexibility led many account owners to limit their contributions to their 529s for fear of getting stuck with penalties for nonqualified expenses — to say nothing of how this limitation may have hampered participation in 529 plans in general (only 19% of parents took advantage of them in 2021).

Now for the good news: Beginning next year, there will be a new type of qualified distribution from 529 plans. In short, account owners can roll over excess funds from their 529 into a Roth IRA, free of tax or penalty.

That being said, there are some rules governing how this works. They are pretty straightforward but also very strict and confusing.

How can I roll my 529 into a Roth IRA?

Effective for distributions after December 31, 2023, 529 account holders can transfer funds to a Roth IRA for a beneficiary. This means that if funds intended for that beneficiary’s college education are not used, those funds can be applied toward their retirement.

The process itself works much like that of a Roth IRA conversion. There are, however, as mentioned, some restrictions. For example:

  • Only beneficiaries can perform the rollover, not the account holders (e.g., parents or grandparents who set up the plan initially).
  • The 529 account must have been open for at least 15 years to be eligible for the rollover.
  • The Roth IRA must be owned by the same beneficiary as the 529 account.
  • Contributions (principal) in the Ohio 529 account must have been there for at least five years before the rollover.
  • The rollover of 529 funds into the Roth IRA is subject to the yearly Roth IRA contribution limit, which is $6,500 for beneficiaries under 50 and $7,500 for those over 50 in 2023.
  • The lifetime maximum amount that can be rolled over from a 529 plan to a Roth IRA is $35,000.
  • Roth IRA contribution limits based on income still apply; beneficiaries must have earned income equal to or more than the contribution amount to perform the rollover.
  • Not all states may allow the rollover, as states may have specific rules regarding excess 529 plan funds transfers to a Roth IRA.
  • Changing the beneficiary to oneself may be possible, but it might reset the 15-year clock, delaying the rollover of 529 funds into the Roth IRA.
  • Government agencies are still clarifying some aspects of the change, and more detailed guidelines may be provided before the law’s effective date in 2024.

Understanding these restrictions and considering individual circumstances before initiating the 529-to-Roth IRA rollover is crucial to ensure compliance and maximize the benefits.

What is the 529 loophole?

2023 has brought another big change to 529 plans: a new FAFSA (Free Application for Federal Student Aid) rule means that as of this year, grandparent-owned 529 accounts are no longer counted towards a student’s financial aid eligibility.

Previously, students had to report any funding from grandparent-owned 529 plans as untaxed income, reducing their FAFSA eligibility. However, under the new rules, students are not required to report cash funding from grandparent-owned 529 accounts on the FAFSA application.

These changes are effective from the 2023-2024 school year.

What are some other types of college savings accounts?

There are two more popular types of college savings accounts of which to be aware:

Coverdell Education Savings Accounts (ESA)

Coverdell Education Savings Accounts are tax-deferred trusts or custodial accounts that enable saving for a child’s future education, functioning similarly to 529 plans with tax-free growth. They have a $2,000 annual contribution limit per beneficiary, and there are income restrictions for eligibility.

Unlike 529 plans, Coverdell ESAs offer more investment flexibility and can be used for various educational expenses beyond just tuition. Considering both accounts’ advantages and drawbacks, some individuals utilize both Coverdell ESAs and 529 plans simultaneously to maximize their college savings efforts.

UTMA and UGMA

Uniform Transfer to Minor Act (UTMA) and Uniform Gift to Minor Act (UGMA) Custodial Accounts allow you, as the guardian, to manage a savings account on behalf of the beneficiary until they reach legal adulthood. Both accounts grant complete control to the child once they come of age, and the funds can only be used for their benefit.

The primary difference between UTMA and UGMA accounts lies in their maturity age, with UTMA accounts maturing at age 25 and UGMA accounts at age 18. These accounts have no contribution limits, offering more flexibility in using the funds. However, this flexibility can lead to unintended spending, as the beneficiary gains control upon reaching legal adulthood.

All options for college savings accounts offer unique pros and cons, and the right strategy for you will depend on your specific circumstances. With so many changes to U.S. tax law in recent years, staying on top of how the latest rules impact you is vital.

If you need help thinking through your alternatives or planning your savings, we stand ready to assist.

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