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Saving For College Costs, Part 1 by CAPT Arnold Lim, USNR (Ret)


College costs have long been expensive and have been rising. For this month and next, we'll look at types of accounts to use, as well as options if these funds are not used up.

Essentially two types of accounts specifically dedicated for college savings exist: Coverdell Education Savings Accounts (ESA) and 529 plans. Both allow funds to grow tax free. Any funds contributed are not tax deductible, but the funds can be later withdrawn and used tax free if used for qualified higher education expenses (e.g., tuition; room and board; computers; class books); else penalties will apply.

* ESA, orginally also known as Coverdell IRA, were created back in 1997 as part of the Taxpayer Relief Act. The annual contribution limit is fairly low, was originally only $500, but now sits at at $2k per child, regardless of how many ESAs are be opened for one child. One can be opened for any child (aka beneficiary) who is less than 18 years old; obviously the younger the child, the better, to allow for more compound growth. Funds can be used for primary, secondary, and college bills. An important disadvantage is that the account's funds must be used up by year that the beneficiary turns 30 years old, else the ESA has to be closed, and funds are distributed and taxable to the child.  Also, income limits exist for the donor: for 2023, eligibility phases out if taxable income for single person is above $95k and stops at $110k, or for married filing jointly, phases out at $190k and stops at $220k. Recently, Vanguard no longer supports creating new ESA accounts nor transferring beneficiary. Advantage: ESAs allow for more options on what the funds can be invested in; similar to a self directed IRA (vs regular IRA), one can direct the investments of an ESA into assets like real estate, crypto currency, and of course stocks/bonds/funds.

* 529 plans: first created in 1996. Advantage: Have much higher contribution limits that are determined by the state that administers each plan. Thus, can allow for larger amounts of money than ESA. 529 plans themselves come in two flavors, pre-paid and a savings account. In the pre-paid variety, one pays premiums to later get the tuition, regardless of any potential increases in that tuition; in essence, protected from cost increases. In the savings account, you make contributions of whatever amount you decide and then later take withdrawals or distributions from the account to pay for any college-associated costs like tuition on your own. Disadvantage is that the investment choices are limited to what the plan administrator allows, similar to how an IRA is very open while a 401(k) is also limited to the plan's option(s). Each of the 50 states can manage a 529 plan. Noted consumer expert Clark Howard has a website with an analysis of which states have better (e.g., more cost efficient) programs.*irement/529-plan/   I personally used Utah's plan, which is very strong.

Next month, we will continue our look at these account types, as well as what to do with excess funds in these account types.

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