School is in session, but are you confident in your investment strategy to pay for it?
For whatever reason, there is not enough discussion on funding and tax strategies for K-12 education.
- Do you intend to send your children to private elementary, middle, or high school?
- Have you ever wondered how you should be saving for and funding that cost?
Let’s explore the top tax-advantaged savings tools for private K-12 education.
Tap 529 Funds For Private Education
529 plans are popular investment vehicles for funding higher education costs in an extremely tax-efficient manner.
These investments allow you to contribute after-tax funds that grow tax-free and are tax-free upon withdrawal when used for qualified educational expenses. Additionally, some states even allow you to deduct contributions from your state income tax return.
Do you think that 529 plans are only for qualified higher education costs?
The Tax Cuts and Jobs Act opened up a wide array of options for parents to make the most of their 529 plan investments. One of the significant changes was giving parents the ability to use $10,000 per year to pay for K-12 educational expenses.
592 plans also don’t have annual contribution limits. While you should consider the $15,000 annual gift tax exclusion threshold, you can certainly plan on contributing quite a bit of money to a 529 plan each year. 529 plans also have a provision that allows you to “superfund” the account by contributing 5 years of your annual exclusion in one lump for a total of $75,000. A married couple can each contribute this amount per beneficiary for a grand total of $150,000.
Embrace The Flexibility of Your Roth IRA
Roth IRAs aren't just retirement goldmines. You can also use these funds to pay for qualified education expenses.
If you're younger than age 59.5, you can withdraw any contributions to these accounts tax-free. But withdrawing any earnings will be fully taxable and subject to a 10% early withdrawal penalty.
For example, let’s assume you contribute $6,000 per year for the past 5 years to a Roth IRA (total contribution of $30,000). Given the growth in your portfolio, your account is now worth $40,000 (a $10,000 gain). If you wish to use these funds to pay for K-12 private education, you can only use $30,000 without any tax or penalty upon withdrawal. There is also a “5-year rule” that states the Roth IRA must be opened and funded for 5 years before the contributions come out penalty-free. The takeaway: if you’d like to leverage a Roth IRA for education expenses, open and fund the account now (even with a very small contribution) to start the 5-year clock ticking.
It’s also important to note that while direct contributions to Roth IRAs are limited to $6,000 per year, many employer 401k plans allow after-tax contributions with immediate conversion to a Roth in the form of a mega backdoor Roth conversion.
While contributions to 401ks, in general, are limited to $19,500 per year for those under 50, the total annual contribution limit is actually $58,000 (including after-tax and employer contributions).
Some employers will allow you to convert after-tax contributions directly to a Roth IRA. Others require you to park those contributions in a Roth 401k until you leave the company. Once the money is in the Roth IRA, you can withdraw any contributions tax and penalty-free (as discussed above).
If you plan on using a Roth IRA as part of a broader education planning strategy, remember that you should prioritize your own retirement nest egg and make a plan to replenish any funds you remove from it. We discussed the pros and cons of using a 529 plan vs. a Roth IRA for educational expenses in detail in this previous blog post.
The Comeback for Custodial Accounts
Custodial accounts are investment vehicles that enable you to invest on behalf of a minor. There are two types to consider: a uniform gift to minors act (UGMA) and a uniform transfers to minors act (UTMA).
You can contribute nearly any type of asset into the account like stocks, bonds, ETFs, mutual funds, real estate, and more. The primary difference between the two is that you can contribute broader assets to a UTMA, like art and collectibles.
Similar to a 529, there are no contribution limits, but mind the annual gift tax exclusion. You can also withdraw the funds “for the benefit of the minor,” which can encompass far more than education costs. You also don’t have to stick with any regular withdrawal or distribution schedule, bringing immense flexibility.
How are the funds taxed? Earnings are taxed at the child's tax rate up to a certain point ($1,100 tax-free, next $1,100 is 10%, and any gains over $2,100 are taxed at parents rate in 2021). The low limit for favorable tax treatment can reduce the vehicle’s overall efficacy.
The Achilles heel? Once the child reaches the age of maturity, which usually ranges from 18-21, the funds belong to them, and they are free to use them as they wish.
Use Your Tried and True Brokerage Account (Just Watch Out for Capital Gains)
Utilizing taxable brokerage accounts is an excellent way to save for larger savings goals, including K-12 education costs.
These accounts have no annual contribution limits, allow for complete flexibility in investment choices, and are one of the most flexible accounts for withdrawing money. In several ways, these accounts should be considered the “catch-all bucket” for savings after you’ve optimized contributions to the available tax-efficient vehicles.
If you plan on using these accounts, you must understand the tax implications. Any realized gain in these accounts (over and above the initial investment) is taxed immediately. The investment’s holding period will determine the tax treatment.
- If held for less than 1 year, you will owe ordinary income taxes on any gain.
- If held for more than 1 year, you will qualify for lower long-term capital gains rates.
Additionally, you will owe taxes on any interest income or dividend payments generated from your investments. It’s important to factor in these future tax liabilities and ensure that you can sell shares, absorb the tax, and still have the target balance to fund the educational goal.
What’s The Best Option for You?
In many cases, we recommend that clients use 529 plans as the primary funding source for education goals, housing anywhere from 50-75% there. You can then use your Roth IRA and brokerage assets to cover any remaining needs.
Funneling all of the contributions to the 529 could end up with a sizeable residual balance that faces taxes and penalties if not used for education expenses. Roth IRAs and taxable brokerage accounts are much more flexible on using the money (although you should be wary of potential tax burdens and withdrawal penalties).
Ultimately, the optimal educational savings strategy is going to be different for every family. It often comes down to prioritizing multiple competing priorities to tailor the plan to your unique circumstances. If you would like to discuss how a K-12 education savings plan fits into your financial plan, send us a note and schedule a complimentary consultation today.