College savings plans: How to save for college while reducing your tax bill

If you’re saving for college, it’s a smart idea to have an overview of the college savings options out there as well as other account types that could help you pay for college. What’s more, you’ll want to understand how each of these affects your taxes.

With rising tuition rates, many parents are considering ways to be more prepared for future education expenses other than traditional financial aid. Saving funds for college early not only provides financial peace of mind, but also has tax benefits now and into future years.

College savings plans like 529 plans, Coverdell Education Savings Accounts, educational savings bonds, prepaid tuition plans, and IRA distributions provide tax benefits while saving money. But how to choose which is best fund for you? Here is a rundown of your options, including the tax benefits and drawbacks of each type of college savings plan.

It’s important to note all of these education savings plans are for qualifying educational expenses at eligible educational institutions. Qualifying expenses typically include tuition, fees, tutoring, required books, and supplies. College savings plans could cover some room and board expenses, but they vary – so be sure to check the details.

Eligible educational institutions generally include colleges, universities or vocational schools that are eligible to receive student aid from the Department of Education.

529 Plan: Qualified tuition programs

You have probably heard of 529 college savings plans, otherwise known as qualified tuition programs. The 529 plan is a tax-advantaged account that helps you save for college costs. These tuition plans allow you to save for qualified higher education expenses at eligible educational institutions. Some programs allow you to prepay future college expenses, as described in the “Prepaid Tuition Plans” section below.

Pros:

• When you set up your account, the earnings on your contributions grow tax-free if distributions are used for qualified education expenses.
• Some states allow contributions to these plans to be excluded from adjusted gross income for calculating your state tax bill. Others may allow a tax deduction for contributions.
• Grandparents can transfer substantial amounts of cash to their grandchildren’s 529 plans without any gift tax complications. This is a great estate planning tool, but it requires some financial planning to maximize the tax benefit. (See more: What are taxable gifts?)
  • Note: Only cash can be contributed; not appreciated assets such as stock. This prevents the contributors from avoiding capital gains taxes on the sale of the assets.
• When it’s time to use your funds, your withdrawal is also tax-free when it’s used for a qualified education expense. This means the qualified withdrawals from a 529 savings plan are excluded from your taxable income.
• You can take up to $10,000 per student in distributions each year for tuition for enrollment or attendance at a public, private, or religious primary school, secondary school, or college with this education savings plan.
• 529 savings balances that cannot be used by the plan’s beneficiary may be rolled over into a Roth IRA in the beneficiary’s name, with certain limitations.
• Plan beneficiaries may exclude up to $10,000, over their lifetime, for distributions used to pay student loan principal and interest.
• There are no income limits on contributions to 529 plans. Also, individuals such as parents, grandparents, and friends may contribute to a beneficiary’s 529 plan.

Cons:

• If there are distributions for nonqualified expenses or to schools that aren’t qualified educational institutions, the distribution to this college savings account may be subject to a 10% penalty on any earnings contained in the distribution.
• Some states do not recognize contributions made to out-of-state plans, and therefore may not allow any state tax benefits from the contribution.
• In some cases, assets in a 529 plan may have a negative effect on a student’s financial aid.
• For a distribution to be qualified, the student must be enrolled for at least half of the institution’s full-time academic calendar.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts, or ESAs, are trust or custodial accounts created to pay for the qualified educational expenses of a specific beneficiary. The beneficiary must be under age 18 or have special needs for you to contribute.

Coverdell ESAs can cover costs of qualified elementary, secondary, and higher education expenses such as tuition, fees, extended day programs, equipment, room and board expenses, uniforms, and other expenses related to enrollment at a private, public, or religious school.

Pros:

• Contributions are not deductible, but earnings grow tax free in the account if distributions are for qualified education expenses.
• You can contribute to these accounts for the previous tax year until the filing deadline (not including extensions).
• Distributions used for qualified education expenses are tax-free.
• Anyone can contribute to a Coverdell if their modified adjusted gross income does not exceed the limit, including the beneficiary. The limit for 2024 is $110,000 and $220,000 if filing a joint return.

Cons:

• Once the beneficiary reaches age 30, the savings account must be distributed. However, it can be rolled over for certain family members.
• These plans require a little more effort to create and administer. There must be a governing document that satisfies various requirements, such as having an IRS-approved bank or entity serve as the trustee or custodian.
• Contributions to each beneficiary are limited to $2,000 per year, even if a beneficiary has more than one Coverdell Education Savings Account.
• There are limitations on how much one can contribute based on adjusted gross income. Any excess contributions are subject to a 6% additional tax for each year the excess contributions remain in the account.
• Distributions for nonqualified expenses or to schools that are not qualified educational institutions may be subject to a 10% early distribution penalty on any earnings.
• No contributions are allowed once the beneficiary reaches age 18 (unless the beneficiary has special needs).

Education Savings Bonds: Can you use savings bonds for education expenses?

Interest from Series EE bonds issued after 1989, or all Series I bonds, may be excluded from income if the bonds are used to pay for qualified education expenses.

There are some requirements to note:

1. You must pay qualified educational expenses for yourself, your spouse or your dependent.
2. Interest on savings bonds (Series EE issued after 1989 or Series I bonds) can be excluded from income if the bonds are used to pay for qualified education expenses incurred only by the taxpayer, the taxpayer’s spouse, or their dependent. For example, a grandparent can’t exclude interest on such bonds by redeeming them to pay for a grandchild’s education (unless the grandchild is their dependent).
3. You may not file using the Married Filing Separately filing status. Additionally, the bond must be issued in your name or in the name of you and your spouse (as co-owners).
4. The owner must be at least 24 years old before the bond’s issue date.

Pros:

• If the requirements are met, the bond interest is not taxable when the bond is redeemed.

Cons:

• The annual purchase limit for the bonds is $10,000 per series (EE or I) per taxpayer.
• There are limitations on how much one can contribute based on adjusted gross income.
• The interest from bond redemptions may be partially taxable if the total cashed out exceeds educational expenses.
• Interest on a bond bought by a parent in the name of their child who is under age 24 when the bond is purchased does not qualify for the exclusion by either the parent or the child.

IRA distributions and paying for college

While IRAs are generally intended to help you save for retirement, you may be able to use your IRA to pay for college. Using this option is only available for your education expenses, or the education expenses of your spouse, children or grandchildren.

Take note: The distribution amounts may be included in gross income based on the kind of IRA and the amount that has been invested and taxed.

Pros:

• You can take an early IRA distribution to cover qualified educational expenses without the 10% additional tax penalty.
• You can use the funds in your account to offset the impact of loan payments while you or an eligible family member is in school.

Cons:

• There are limitations on how much one can contribute based on adjusted gross income.
• You can’t use retirement account funds to pay off student loans post-graduation.
• Even if your qualified distribution is not subject to the 10% early withdrawal penalty, it is still a taxable distribution that can increase your income and disqualify you from other tax benefits.

Prepaid tuition plans

Prepaid tuition plans are a type of 529 college savings plan that could be a good investment option if tuition inflation concerns you. Only a few states and institutions offer this plan, including:

• Florida
• Illinois
• Maryland
• Massachusetts
• Michigan
• Mississippi
• Nevada
• Pennsylvania
• Texas
• Virginia
• Washington

With this plan type, you can lock in the costs of future education expenses at today’s levels. You will either make a larger one-time payment or smaller monthly payments to fund the account.

Pros:

• Contributions can grow tax-free.
• Distributions aren’t taxed if used for qualified education expenses.
• States may offer a tax deduction for contributions made to their prepaid tuition plans.

Cons:

• They are more restrictive than traditional 529 plans because they are location and institution specific. In addition, they might only cover specific fees or partial tuition.
• If you use the money for nonqualified expenses, you could face a 10% penalty on the account’s earnings
• However, the plans are based on in-state public schools, so if you or your child moves to a different state or wants to attend an out-of-state private school, you may need to take advantage of other college savings plan options. Also, while some plans may allow for out-of-state usage, they may not cover the full cost of tuition and could impose penalties or reduced benefits.

Get help navigating taxes and college savings accounts

The above options are great savings tools to help you maximize your tax benefit and save funds for higher learning.

Keep in mind that there are also education tax credits to help offset college costs, which can be used with these savings plans.

Whether you choose to file with a tax pro or file with H&R Block Online, you can rest assured that we’ll get you the biggest refund possible.