It’s no secret that education costs in the United States have been on the rise over the last two decades. In fact, a college education now ranks as the second largest expense a person will have in their lifetime, right behind buying a home. While a college education was not always deemed as a necessity, between 1990 and 2020 the number of college students rose from 13.8 million to nearly 20 million as more and more people view a college diploma as the only way into the middle class.
While we don’t know what the future will hold, it’s safe to say that the desire for higher education will remain constant through the next decade, making it more important now than ever to save for the next generation’s future.
Saving for their future with tax benefits
When it comes to investing in and saving for a child’s future, there are two main ways of going about it, each with their own pros and cons depending on your overall saving goals and how you’d like the children to be able to access the funds.
First up is a 529 Plan, legally known as a qualified tuition plan. This type of investment account is designed to save for future higher-education costs. The funds set aside in these plans enjoy tax deferred growth and tax-free withdrawals, as long as they are used for qualified expenses such as tuition, books and supplies, room and board, tuition for private school and other qualified education expenses.
Anyone can open a 529 account for a designated beneficiary and, as the account owner, they are in charge of contributing to and managing the investment choices, which often include age-based target funds to align with the beneficiary’s anticipated enrollment date. When it comes to making contributions, the account owner can do so monthly, much like for a retirement fund, or in one lump sum.
This qualified tuition plan not only offers tax benefits for the future, but also in the present year. The annual gift tax exclusion has gone up in 2022, to $16,000 per individual. Therefore, an account owner can contribute up to $16,000 to a 529 account without having to file a gift tax return. A portion of this is deductible may even appear on your state income tax return, depending on the plan itself and the state you live in. In New York State, contributions up to $10,000 are deductible from NYS taxable income if filing a joint return (or $5,000 for single filers).
For parents and grandparents, funding a 529 account is a great estate planning technique as owners of these type of accounts have the ability to superfund or opt for the five-year election, essentially lumping five years of contributions or gifts into a single year. Using the data for 2022, for example, an account owner would be able to contribute $80,000 for their beneficiary’s account using this technique.
That being said, what happens if the account beneficiary decides college or higher education is not the path for them or they receive a full scholarship and no longer need the funds? With a 529 account, the owner has the option to change the beneficiary to another family member.
Entrusting their future without a trust
Along with the 529 Plans are standard investment accounts, Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA). These accounts allow an adult to save and transfer assets to a minor without establishing a trust. Contributions made to these accounts are irrevocable, meaning they are permanent once they are transferred to the account. They are also placed in the name of the child but are controlled by the adult until the child reaches the age of majority in their state, 21 years old in New York, for example.
Unlike 529 Plans, these accounts do not have the same tax benefits (i.e., tax deferred growth, tax free withdrawals, etc.), but offer greater flexibility in what they can be used for. This makes them a better choice if an adult doesn’t want to limit the child to a specific life path, but rather provide assistance with a purchase of their first car or home. These funds can also still be used to assist with higher education costs, but earnings are taxed at the child’s tax rate up to a certain amount. Another perk of these account types is that if the child is still a minor, the funds can be accessed and used to pay for items that benefit them like clothes and summer programs; they do not have to be held off until they reach adulthood.
It is important to note that when comparing 529 plans to UGMA/UTMA accounts, the latter often impacts financial aid at a greater level because they are viewed as the child’s asset, rather than the adults. This can make it more difficult for the child to apply for and receive certain types of federal assistance like FAFSA as having these assets can reduce their eligibility by nearly 25% of the asset value compared to the 5.56% of a 529 plan.
All of this to be said, the two options listed above are just that – options. When it comes to deciding the right way to save for a child’s future, loved ones have these and other saving options to set the next generation up for success, no matter the path they choose to take towards their future.
John Knisley is a financial planner with Tompkins Financial Advisors, Western New York region.