Higher education is expensive and Congress is happy to help out voters by piling on the tax breaks to help pay the bills.
State college-savings plans have always been appealing, with earnings that were tax-deferred and then taxed at the student's rate when used to pay college bills. But now that the earnings are completely tax free, 529 plans almost irresistible. Consider what happens to $100 a month invested over 18 years at 8%. In a taxable account, with taxes shaving 25% from the earnings each year, your savings grow to nearly $39,000. The same amount invested in a 529 and growing tax free will produce almost $50,000 to pay college bills.
Most states exempt earnings from state taxes, too. Even better, about 20 states allow residents to deduct contributions on their state tax returns.
You can contribute to a 529 plan no matter what your family's income, and the contribution ceilings are high–more than $200,000 in some states. Most plans allow you to open an account with as little as $25 or $50, and anyone can add to the kitty, making the plans a great place for Grandma or Aunt Sue to direct the occasional birthday or holiday gift. The money may be used for qualified higher-education costs (tuition, room, board, books and transportation) at any accredited college in the U.S., and some foreign institutions.
And a reassuring benefit to many parents is that the account owner controls the money until it's used for college—unlike a custodial account, of which the child generally gains control at age 18 or 21. So if your child snubs the academic life, you could transfer the account to another family member with anticipated college expenses—yourself included. The new law also lets you transfer accounts between cousins, which is a boon for grandparents who might want to shift funds among their grandchildren. You could even take the money back for another purpose, although the earnings would then be taxable and you'd pay a penalty equal to 10% of earnings.
The flexibility and tax benefits make 529 plans almost perfect havens for college savers. The spoiler is that the state controls your investment options, and once you choose one you can't change your mind. But even that flaw is less of a limitation than it used to be because states are expanding their investment choices, and the new law gives you an easy out.
Most 529 plans rely on "age-based" portfolios of mutual funds that invest mostly in stocks when a beneficiary is young and gradually shift to bonds and money-market funds as the child ages. That's exactly how a parent should invest for a child's college expenses, gradually tamping down risk as the tuition bills near—so these self-adjusting portfolios can be blessedly simple buy-and-forget investments. But experienced investors in many states have found the one-size-fits-all choices too conservative. In New York, for instance, the original managed portfolio was 25% in bonds for a newborn, and reached a 50-50 split between stocks and bonds by the time a child reached age 8. That's just too conservative for many investors' tastes.
So now states are adding more choices, such as multiple age-based portfolios with conservative, moderate and aggressive asset allocations, as well as 100% stock and fixed-income funds that can be used alongside an age-based portfolio to fine-tune the overall allocations to suit you. Nebraska's plan, for example, offers investors a generous ten choices: four age-based portfolios and six other mutual funds, including an S&P 500 index fund. Like savings plans in most states, Nebraska's plan is open to any U.S. resident.
What if you're unhappy with the performance of the portfolio you've chosen? You have a once-a-year chance to switch to another portfolio offered by the plan you're in or you can roll your money into another state's plan and make a new investment choice that way. Be sure to watch the administrative and management fees attached to the account.
It was nice that Congress decided to change the name of these accounts from education IRAs, since they have nothing to do with retirement. It's even better that the lawmakers decided to quadruple the old $500 a year limit on contributions. You can now contribute up to $2,000 a year. ESAs are offered by banks, mutual funds and brokerage companies—and you have full discretion to buy and sell what you want. You get no tax deduction when money goes into the account, but earnings accumulate tax-free.
If you contribute the maximum for a newborn each year until he or she is 18 and the account earns an average of 10% a year — which is the historical long-term average return in the stock market even after the recent bear market— the account will grow to just about $100,000—probably enough to pay for four years at a public college. If you want to save more, you can now supplement your savings with contributions to a 529 plan. Congress has eliminated the ban on making contributions to both kinds of plans in the same year.
The new tax law remedies another serious shortcoming. Until a couple of years ago, you could not take a Hope or Lifetime Learning tax credit in the same year you make a withdrawal from an ESA. That restriction is now gone.
Another plus is that you can use tax-free withdrawals from ESAs to pay for private elementary and high school expenses. The money can also be used, for example, to pay a tutor who aids a child in public school or even to pay for a child's home computer. If pre-college tuition bills are in your future, you could save for them in an ESA and use a 529 plan for college. As with a 529 plan, you control the account until it's used for a qualified expense; you can transfer the money to another family member if the original beneficiary doesn't go to college; and you pay a 10%-of-earnings penalty if the money is used for a nonqualified expense. One distinction: No ESA beneficiary may be older than age 30, while in most states 529 plans may be used for students of any age.
There are income limits for contributing to ESAs. You can contribute fully only if you're adjusted gross income is less than $95,000 on a single return or $190,000 on a joint return.