Tax-Smart Education Funding

For parents and grandparents who want to give the next generation a leg up in life, providing funding for education costs is typically a high priority. But it’s not getting any cheaper. According to the National Center for Education Statistics, the cost to obtain a degree at a public four-year institution has nearly tripled since 1980. And, while the rate of tuition inflation slowed somewhat during the 2020–21 COVID pandemic, borrowers still owe some $1.77 trillion in student loan debt.

Two principal savings tools for education funding are receiving increased attention over the last few years: 529 plans and Roth IRAs. Both these tools offer significant tax advantages while providing education funding. Let’s take a look at both, along with some strategies that can benefit plan owners, students, or both.

529 Plans

Also called tuition savings plans, these plans are named for the section of the Internal Revenue Code that created and regulates them. Each state offers its own version of the 529 plan, but you don’t have to join the plan offered by your state of residence. If you live in a state that provides an extra state income tax deduction for using the state’s plan (such as Colorado, Iowa, Illinois, Louisiana and New York) those can provide an extra boost to your ability to save. If your state doesn’t offer any enhanced benefits, then it may be more beneficial to use a low-cost out-of-state plan. To see a list of plans offered by each state, visit the website.

These state-administered plans allow deposited funds to grow without taxation and, when withdrawals are made to pay qualified educational expenses, the withdrawals are not taxed as current income. Plans can be owned by the students themselves, by the parents, or by a grandparent or other relative, and the beneficiary (the person incurring the expenses) can be changed, so that if an older child has finished college and there is still a remaining balance in the plan, the beneficiary can be changed to a younger sibling who still needs to pay for school. And, since the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, 529 plans can also be used to pay expenses for K-12 education at private institutions, in addition to college. In fact, since the passage of the SECURE Act in 2019, up to $10,000 in a 529 plan can also be used to pay off student loans.

For high-net-worth families, 529 plans can also be a useful estate planning tool. Because they permit the transfer of larger sums, these plans can be a helpful way to reduce the size of a taxable estate. Each state sets its own limits for how much can be deposited into a 529 plan over the life of the plan. Limits can change annually, so if you are considering this, be sure to consult with your tax and estate planning advisors.

Roth IRAs

Anyone with earned income up to a certain amount (in 2023, $151,500 for single filers and $227,000 for couples) can fund a Roth IRA. Unlike a traditional account, the Roth account does not provide a deduction for contributions. Like a traditional account, however, funds in the Roth account grow and compound free of taxation, and if funds are withdrawn for a qualified purpose, the withdrawals are not taxed as current income. Traditionally, as implied by the name, these accounts are thought of as vehicles for funding retirement. But paying for qualified educational expenses is also considered a valid use of Roth funds.

Children with earned income can deposit those earnings into a Roth account in their name, up to $6,500 (in 2023) or 100% of earned income, whichever is less. (Alternatively, parents or grandparents can make contributions to the account, as long as they don’t exceed the amount of the child’s earned income). These funds can then be used when the child needs them for college or other qualified educational expenses.

However, any funds disbursed from an account held in the child’s name could affect their subsequent eligibility for financial aid, if that is a consideration. Similarly, funds disbursed from a parent’s or grandparent’s Roth IRA account will be counted as income on the Free Application for Federal Student Aid (FAFSA) form for the year it is paid, potentially affecting the next year’s financial aid offer. 

On the other hand, since the passage of SECURE 2.0 in 2022, Roth IRAs offer another potential tax benefit, when used in conjunction with a 529 plan. The new law allows rollovers of unused portions of 529 plans into Roth IRAs, giving students, parents, grandparents, and others the opportunity to convert extra education funding assets into retirement assets for the new graduate. There are some requirements, however:

  • The 529 plan must be at least 15 years old;
  • Annual rollovers are limited to the amount of the maximum Roth contribution, adjusted for inflation;
  • The lifetime maximum for such rollovers is $35,000, with no inflation adjustment.

That said, this can be a great way to convert education funding into a long-term retirement investment while retaining tax-free growth.

At The Planning Center, we specialize in helping clients achieve important financial goals—like education funding—while offering tax-efficient guidance. To learn more, visit our website and read our recent article, “Gifting for Grandparents: Some Points for Consideration.”