Because of the number of years involved, the postponement of taxes plays a vital role in maximizing the value of a college savings plan. The deferral of taxes provides extra leverage as additional earnings on the unpaid taxes accumulate. Parents or guardians of future college students can compare differing tax strategies and select one that better suits their individual situation.
Section 529 plans
The most widely known option for saving money for future education expenses is a 529 plan. Also known a a qualified tuition plan, a 529 plan is sanctioned by section 529 of the Internal Revenue Code. Your contributions to a 529 plan do not receive a federal tax deduction up front. However, subsequent account earnings are never taxed as long as they are eventually spent on qualified education expenses.
Section 529 plans are administered by the individual states. Even though states have their own separate plans, you can generally open an account in any state. The various states have differing fee structures for their respective 529 plans, so an additional factor to consider is the potential for a state income tax deduction.
Even though there is no up-front federal tax deduction for contributions, many states provide a deduction for their residents who fund their own in-state 529 plan. The potential drawback to a 529 plan account is that a distribution of earnings becomes taxable if it is not spent on qualified education expenses. A taxable distribution from a 529 plan is also assessed an additional 10 percent penalty.
Individual retirement accounts
If you prefer to have a greater degree of flexibility in a college savings plan, you might consider funding an individual retirement account instead. Although typically used to build retirement assets, an IRA could also serve as a potential college savings plan. Early withdrawals from an IRA are normally subject to a 10 percent penalty, but there is an exception for distributions used for post-secondary education expenses.
At age 59 1/2, the owner of an IRA can make withdrawals for any purpose, without a penalty. At a younger age, IRA owners can avoid the penalty by applying withdrawn funds to the college expenses of their children or their children's descendants. To claim the education exception, IRS Form 5329 is filed along with your Form 1040.
Other variables also need to be considered before selecting your ideal college savings method. Section 529 plans may be treated differently from individual retirement accounts for purposes of obtaining grants and financial aid. Contact an accountant who performs financial planning for more advice on college savings planning.