Education & other plans

Outside of retirement plans, there are other tax-beneficial plans eligible to those saving for education or persons considered disabled. We’ll discuss the following accounts in this chapter:

• Coverdell ESAs
• 529 plans
• ABLE accounts

Coverdell ESAs

Coverdell education savings accounts (ESAs) provide a tax-friendly way to save for a child’s education. ESA funds can be used to pay for costs related to virtually any type of education, including grade school, middle school, high school, vocational school, and college.

An annual non-deductible contribution limit of $2,000 per child per year may be made into a Coverdell. Similar to Roth IRAs, contributions are non-deductible, and high-income earners are prohibited from contributing. Contributions can be made until the child reaches age 18.

From there, the assets are invested and grow tax-sheltered. Funds are available to be used for education-related costs when they arise. Coverdell distributions used to pay for educational expenses (known as qualified expenses) are not subject to taxation. This is the big benefit these accounts provide. Investment gains are typically taxable, but not with Coverdell ESAs (assuming the distributions pay for qualified expenses). However, a 10% penalty and ordinary income taxes apply if a withdrawal is not linked to qualified education expenses.

All assets in a Coverdell ESA must be distributed by the time the account beneficiary reaches age 30. If educational expenses don’t exist, assets can be rolled over into another family member’s Coverdell ESA as long as they are under age 30.

529 plans

529 plans, also known as qualified tuition programs (QTPs) are very similar to Coverdell ESAs, but are mainly utilized for college expenses. Each US state has its own unique 529 plan that it sponsors.

Types of 529 plans

Two general 529 plan types exist: prepaid tuition and college savings plans. Prepaid tuition plans are exactly what they sound like. Investors contribute money for a future college student and “prepay” tuition at today’s rates instead of being assessed in college (when tuition rates would be higher). These plans mitigate the risk of rising college costs, which have risen much faster than inflation in recent years.

College savings plans involve investing in state-approved funds similar to mutual funds. Investors typically have plenty of choices, which include everything from money market funds to aggressive growth funds. Also, many plans provide target date funds that are structured around the year the funds are needed (e.g., a 2040 fund for a student projected to attend college in the year 2040). Initially, target date funds are more aggressive, but become more conservative (safer) over time. Many of these funds evolve into money market funds when the target date is reached.

Investing for future college expenses is often a long-term objective, especially when saving for a young child. Frequent changes to 529 plan investments are not allowed to encourage a long-term mindset. The plan participant (the person managing the plan, discussed below) may only make two changes to their 529 investment allocation per calendar year. The plan participant can also move from one state’s 529 plan to another state’s 529 plan once per calendar year.

529 plan parties

There are two parties in each 529 plan - the plan participant and the beneficiary. The plan participant plays a similar role as a custodian in a custodial account. These are often parents or other family members managing assets for a child. Their role includes investing 529 assets into suitable portfolios and distributing funds when educational expenses occur. The beneficiary is the person who the 529 assets are meant to support, and often is the child or close family member of the plan participant.

One unique aspect of 529 plans is the amount of control the plan participant maintains. Assets placed into the plan are the property of the plan participant, no matter how old* the beneficiary is. Unlike UGMA and UTMA accounts, there is no requirement to turn the assets over to the beneficiary once they reach adulthood. In fact, the plan participant is under no obligation to do anything with the 529 funds. If the child doesn’t go to college, there’s no requirement to give them the money!

*529 plans have no age requirement. Any adult can open a 529 account for a beneficiary at any age.

The plan participant also controls who the beneficiary is. Beneficiary changes can be made without tax consequences if the new beneficiary is a family member. The IRS considers the following as eligible family members for non-taxable beneficiary changes:

• Natural or legally adopted children
• Parents, stepparents, or grandparents
• Siblings or stepsiblings
• Nieces or nephews
• Aunts or uncles
• Spouse of any of the above
• Spouse of the beneficiary
• First cousins

529 plan contributions

Contributions to 529 plans are made with after-tax money at the federal level. Meaning, contributions to these plans do not offset federal income tax liabilities. However, some states provide a state tax deduction for contributions. The key word is some - several states do not offer a state tax deduction (especially those without an income tax).

Although contribution limits are not a concern, gift taxes may apply. A person gifting more than $18,000 to someone other than their spouse may be subject to federal gift taxes. If a grandmother contributes more than $18,000 to her grandchild’s 529 plan, she may owe taxes.

There is a way to avoid gift taxes, even if the amount contributed is more than $18,000. The IRS allows a one-time contribution of up to five times the $18,000 annual limit. For example, a grandmother could contribute up to $90,000 ($18,000 x 5) to her grandchild’s 529 plan and avoid gift taxes. If she were to contribute anything more in the next five years, she would be subject to taxes.

Once funds are contributed and invested, the assets grow tax-deferred over time. The IRS cannot tax any capital gains or dividends received as long as the assets are parked in the account. 529 plans generally require automatic reinvestment of capital gains and dividends.

529 plans have contribution limits, but they vary state by state, and you won’t need to know them for the exam. Also, contribution limits are substantially high. For example, California’s cumulative contribution limit per person is $529,000. As you’re probably aware, college is expensive! Also, 529 plans do not have phase-out rules, so even high-income earners can contribute.

529 plan distributions

Distributions (withdrawals) are not taxable as long as the funds are used for qualified educational expenses. The definition of a qualified 529 expense is a bit narrower than it is with Coverdell ESAs (where virtually all education-related expenses are qualified). These typically include:

• Tuition
• Textbooks
• Computer equipment
• Room and board (if the student is enrolled at least half-time)
• Apprenticeship programs
• Costs related to special needs students
• Payment of student loans (up to $10,000)

529 plans are primarily used for college expenses. However, up to $10,000 per year can be used for private, public, or religious schools below the college level*. If college savings plan funds are not used for education, the account owner is subject to ordinary income taxes and a 10% penalty (only on the gains; the basis is always tax-free). However, if the beneficiary receives a scholarship and no longer needs the 529 plan, assets may be distributed without the 10% penalty (ordinary income taxes will still apply to gains). Generally, distributions must be taken in the same calendar year a college expense is assessed.

*When paying for educational expenses below the college level (K-12), only tuition costs count as a qualified expense. All other expenses are non-qualified, subjecting withdrawals to taxes plus penalties.

ABLE accounts

The Achieving a Better Life Experience (ABLE) Act of 2014 created what we know today as ABLE accounts. Significant expenses can exist for people with a disability, and ABLE accounts were created to help pay for those expenses.

Additionally, ABLE accounts provide an efficient way to save money while not risking the loss of other forms of aid. Oftentimes, one must be considerably poor to qualify for government benefits. If a disabled person owned a reasonable amount of assets in a typical brokerage account, they might be ineligible for certain benefits like Medicaid. The ABLE Act was signed into law to allow people with disabilities to gain access to tax-beneficial accounts without jeopardizing their access to other government benefits. Most of the time, assets held in ABLE accounts are not factored into eligibility requirements for benefits like Medicaid.

Contributions to ABLE accounts are made with after-tax dollars that are non-deductible, but some states allow a state tax deduction. Assets are invested and grow on a tax-sheltered basis. Similar to Coverdell ESAs and 529 plans, distributions are tax-free if spent on qualified expenses. For ABLE accounts, these include medical expenses, housing, job training, and educational expenses,

To be eligible to open an ABLE account, the investor must be considered disabled by age 26. However, the account does not need to be open by that age. For example, a 40-year-old individual who became disabled at age 24 would be eligible to open an ABLE account.