There are three primary ways to save for education expenses:
Educations Savings Account (ESA)
Section 529 Plan
The taxable account is the least preferred method as dividends and interest may be taxed each year and an eventual sale may lead to the taxation of capital gains.
Education Savings Account (ESA):
Education Savings Accounts (ESA) grow tax-deferred with subsequent distributions being tax free for qualified expenses. However, ESAs have limits to the annual contributions allowed (as of 2021, $2,000 per year, per beneficiary) as well as income limits for contributors. ESAs can be used for elementary and secondary expenses in addition to post-secondary education expenses.
Section 529 Plans:
Section 529 Plans, which are sponsored by individual states, allow assets to grow tax-deferred with subsequent distributions being tax-free if used for qualified education expenses (K-12 and college). There are no income limitations and each state may or may not have tax incentives for their program. The Commonwealth of Virginia allows for a $4,000 state income tax deduction for each account per year.
Most Section 529 state college savings plans allow parents, grandparents, other relatives, and friends to contribute to an account. Grandparents can set up and manage accounts in the same manner as parents. The account owner makes all decisions and retains ownership of all assets. However, for estate tax purposes, the IRS does not consider these assets to be in the owner's estate if the designated beneficiary is not the same as the owner.
What needs to be done before opening an account?
First, research the various available programs. There are many and each plan is unique. Investors should look for the investment strategies, tax benefits, and other incentives that best suit their needs and those of the beneficiary. Often, a person's home state will offer a plan with advantages that other plans do not have.
What about state prepaid tuition programs?
The prepaid programs offered by individual states vary greatly. Virginia's prepaid program has several serious limitations that need to be considered before making a decision. Also, prepaid tuition programs pay for tuition only, which is approximately half of the total cost of college.