Tax-Deferred and Tax-Free Investments

Tax-Advantaged Education Plans

For more detailed information on this subject see the Learning Center "College Funding" There are several plans that provide tax-deferred or tax-free earnings when used for your child's education.

Coverdell Education Savings Accounts

In 2002, the Education IRA was renamed the Coverdell Education Savings Account.

These accounts work very much like a 529 plan, offering tax-free investment growth and tax-free withdrawals when the funds are spent on qualified education expenses. However, in addition to college expenses, certain K-12 purchases are also considered qualified when using a Coverdell ESA.

Taxpayers may make nondeductible contributions to a tax-favored account designed specifically for college, elementary, or high school education expenses—a Coverdell Education Savings Account (formerly known as an Education IRA).

Contributions of up to a total of $2,000 per year, per beneficiary, may be made to an account for the benefit of a beneficiary who is under age 18 (students with special needs can be 18 years of age or older).

There is an income phase-out for contributions for taxpayers with Modified Adjusted Gross Income (MAGI) modified AGI above $95,000 ($190,000 for joint filers).
No contribution will be allowed once Modified Adjusted Gross Income (MAGI) modified AGI reaches $110,000 ($220,000 for joint filers). These amounts are effective for 2020 and 2019.

SUGGESTION: If your modified adjusted gross income exceeds the limits, have the child's grandparent or other relative establish the account and make the annual contribution. Also consider making a gift to your child who can then contribute to his or her own Education Savings Account.

SUGGESTION: Contributions can be made to an Education Savings Account regardless of whether or not the owner has earned income.

Earnings in an Education Savings Account grow tax-free, and are never taxed provided they are used for the beneficiary's qualified education expenses. The American Opportunity Tax Credit or the Lifetime Learning Credit can be claimed for the eligible student in the same year as an Education Savings Account distribution, as long as the distribution is not used to pay for the same costs used to claim the education credit. If withdrawals are not used for qualified education expenses, withdrawn earnings are included in the beneficiary's taxable income and are subject to an additional tax of 10%.

IMPORTANT NOTE: If the balance of an Education Savings Account is not distributed before the beneficiary reaches age 30, the account must be emptied upon attainment of that age unless the individual is a special needs beneficiary. The earnings in the account are taxed at the beneficiary's income tax rate and are also subject to a 10% penalty since they will not have been used to pay qualified education expenses. These taxes can be avoided if the account balance is rolled over to another Education Savings Account benefiting a different beneficiary, who is a member of the family of the original beneficiary.

Here are some other facts regarding the Education Savings Account:

  • Contributions qualify for the annual gift tax exclusion.
  • An Education Savings Account can be set up for any child under 18; contributions generally cannot be accepted after the child's 18th birthday, unless the beneficiary is a special needs beneficiary.
  • There is no limit on the number of Education Savings Accounts that may be established for a particular child, but the maximum aggregate contribution for any one child in any calendar year is $2,000.
  • Contributions are not deductible.
  • Only cash contributions are allowed.
  • Subject to the applicable income limits, any individual may contribute to an Education Savings Account; the contributor does not have to be a relative. A child may contribute to his or her own Education Savings Account.
  • A child may take tax-free withdrawals to pay qualified education expenses even if he or she is enrolled at an eligible educational institution less than full time; enrollment on a half-time or less-than-half-time basis will qualify.
  • Qualified education expenses include tuition, fees, books, supplies, room and board, and equipment. A student must be enrolled on at least a half-time basis in order for room and board expenses to be considered qualified education expenses.
  • The account is considered an asset of the parent when applying for financial aid.
  • If the beneficiary dies, the value of the account is included in his or her taxable estate, not in the account owner's estate.

If you are eligible to establish an Education Savings Account and make the maximum annual contribution of $2,000 at the beginning of each year for 18 years, assuming a 6% rate of return, the account will have a value of $65,500 at the end.

Qualified Tuition Programs

Qualified Tuition Programs (QTPs), also referred to as Section 529 Plans, generally have a tax-favored status and offer another way to invest for college. Individuals may participate in either a prepaid tuition plan or utilize a higher education savings account plan. Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax professional before investing.

Prepaid Tuition Plan

These programs are administered by a state or eligible educational institution. Under these plans, participants purchase tuition credits or certificates for a designated beneficiary, who is then entitled to a waiver or partial payment of qualified higher educational expenses. Contract purchasers prepay tuition and fees for a set number of academic years while locking in current tuition rates. In-kind distributions from these plans, such as a waiver of tuition, are generally excludable from gross income. To be excludable, the distributions must be used for qualified higher education expenses.

Higher Education Savings Account Plans

These programs are administered by a state. Under these plans, participants make contributions to an account that is set up to meet qualified higher educational expenses of a designated beneficiary of the account. There are no income limitations with regard to making contributions to the plan.

Contributions are made to a state's savings account, and are generally managed by private investment or insurance companies. Each state imposes a limit on the amount of contributions that can be made to the plan per beneficiary, and on how large the account balance can grow. Some states allow a state income tax deduction for contributions made. These plans generally allow for the interest earned to be withdrawn free of federal and state tax. The withdrawals must be used for qualified higher education expenses. If withdrawals are made for purposes other than qualified education expenses, the amount of earnings that are withdrawn are taxed at the beneficiary's income tax rate and are also subject to a 10% penalty.

There are rules that the federal government has established, which must be adhered to under both types of plans. For example, the contributor is limited in exercising investment discretion, and the interest accumulated within the account cannot be used as security for a loan. There are other rules to be followed, and a state or eligible educational institution may also give direction regarding how its particular program works. American Opportunity and Lifetime Learning tax credits can be claimed in the same year as QTP distributions, as long as the QTP distribution is not used to pay for the same costs used to claim the education credit.

Individuals can contribute to both QTPs and Education Savings Accounts on behalf of the same beneficiary. Amounts in a QTP can be rolled over to another state's plan once per year.

SUGGESTION: The American Opportunity Tax Credit or Lifetime Learning Credit can be used in conjunction with a Qualified Tuition Program.

SUGGESTION: Assets in a QTP are treated as the parent's assets when applying for financial aid. Contributions to QTPs qualify for the annual gift tax exclusion. The person contributing the money to the program may elect to treat the contribution as if made over a five-year period for purposes of the annual gift tax exclusion.

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