529 Plans and more: Innovative and effective ways to pay for education

Today, we talk about education as a lifelong journey. It starts with school, but it never really ends. The associated costs have also matured and now resemble longer-term budget items, such as housing and health care. Paying for education has become a major investment—one that often requires years of careful planning. As the costs keep rising, you should approach funding educational expenses, such as tuition, extension programs and advanced professional training, like any other kind of investment that needs a strategy built for your specific needs.

One of the most challenging aspects of crafting such plans is predicting the future educational funding needs for your loved ones, or yourself. The right solution may be a mix of tried-and-true tools with innovative, lesser-known strategies to help plan for the uncertainty.

Here are some strategies that may help cover today’s expected and sometimes unexpected, educational costs.

A 529 plan is a tax-advantaged way to invest for future education expenses. There are various advantages of investing in a 529 plan as well as planning strategies to be aware of. Earnings in a 529 plan grow tax-deferred, and withdrawals are generally exempt from federal and state income taxes if the funds are used for qualified education expenses including tuition, fees, room and board and supplies. Many states also offer a state income tax deduction or credit for contributions to 529 accounts but may limit the availability of such credit or deduction to only those contributions made to that state’s sponsored 529 plan.

529 plans offer gift tax and accelerated contributions opportunities to gift potentially significant amounts from your estate while still retaining control of the assets as the account owner. For federal gift and estate tax purposes, your 529 plan contribution is considered a completed gift to the beneficiary and generally qualifies for the 2024 annual gift tax exclusion of $18,000 ($36,000 for married couples electing to split gifts), enabling you to make contributions without being subject to the federal gift tax.

Additionally, for 2024, you can frontload your contribution to as high as $90,000 in one year per account/beneficiary ($180,000 for married couples electing to split gifts) and elect to take that contribution into account for purposes of the annual gift tax exclusion over a five-year period.¹ The five-year gifting election is unique to 529 plans and accelerated contributions increase the time that assets can potentially grow tax-free, boosting the potential account growth.

At times, a portfolio of zero-coupon municipal bonds can be a smart way to save for college. This type of fixed income security does not pay interest but instead can be bought at a substantial discount to its face value, which it pays in full at maturity, providing a lump sum equal to the initial investment plus imputed interest. A big plus with these bonds: when purchased from a government entity, their interest is often exempt from federal income tax and usually from state and local income tax as well.

When a gap looms between the cost of education and the ability to pay when due, most families reach for student loans by default. But they’re not always the right option. Interest rates on some student loans can exceed 7%; what’s more, for unsubsidized loans, that rate begins accruing the minute the loan is made, even though payments don’t start until after your child graduates.

Many parents understandably want their children to have some "skin in the game"—and student loans certainly lock in the need for long-term responsibility. But you may want to balance that against the weight of educational debt that many students end up carrying long after graduation.

One strategy that parents often overlook is to borrow against their own assets. Parents can then make a loan directly to their children to pay for education. As a borrower, the child must still bear the responsibility of paying back the loan, which typically may carry lower interest rates. The family "lender" may choose to have the child refinance the loan upon leaving or finishing school, or, if it is not paid back, the "lender" may choose to deduct it from an inheritance or simply forgive the loan to the child.

529 plan account owners may also withdraw tax-free up to $10,000 to pay student loans, which often account owners plan to do if the student successfully completes their studies.

The best-laid plans must account for potential detours. Some children choose to take a gap year for travel, volunteering, or real-world job experience. Others may choose to attend college overseas, or study abroad for a semester.

In many circumstances, you may be able to use 529 plan funds tax-free to pay for those options or some expenses related to them. For example, 529 funds may be used for eligible international schools. Additionally, there’s no time limit on 529 plans. The funds can stay invested and continue compounding while your child explores their passions.

Always keep your overall financial well-being in mind. For example, avoid underfunding your retirement in favor of education. Seek good financial advice to determine the best funding ratios for you and your family, especially if you have multiple financial goals.

The source of this article, 529 Plans and More: Innovative and Effective Ways to Pay for Education, was originally published on September 20, 2023. The original content has been modified for E*TRADE from Morgan Stanley audiences.

Article Footnotes

¹ Assets can accumulate and be withdrawn federal income tax-free only if they are used to pay for qualified expenses. Qualified expenses include tuition, fees, room and board, books and supplies at virtually any accredited post-secondary school. Effective January 1, 2018, the definition of qualified education expenses expanded to include tuition for K-12 schools, as a result of the 2017 Tax Cuts and Jobs Act. The new tax law limits qualified 529 withdrawals for eligible K-12 tuition to $10,000 per beneficiary per year and state tax treatment will vary on a state by state basis. The state tax treatment of K-12 withdrawals is under review by many states. Account owners should consult with a qualified tax advisor prior to making such withdrawals as they may be subject to adverse tax consequences. Earnings on non-qualified distributions will be subject to income tax and a 10% federal income tax penalty. Note, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 signed into law Friday, December 20, 2019, expands the definition of qualified higher education expenses for federal income tax purposes to include certain costs associated with qualifying apprenticeship programs and up to $10,000 (lifetime limit per individual) in amounts paid towards qualified student loans of the 529 plan designated beneficiary (or such beneficiary’s sibling). Note, however, using 529 plan distributions to repay qualified student loans may impact the deductible of student loan interest. This new provision applies to 529 plan distributions made after December 31, 2018. The state tax treatment of 529 plans (including the state tax treatment of contributions and distributions) may be different from the federal tax treatment and may vary based on the particular 529 plan in which you participate and your state of residence. If the applicable state tax law does not conform with the federal tax law, 529 plan distributions used to pay certain expenses, such as principal and interest on qualified student loans and/or qualifying apprenticeship costs, may not be considered qualified expenses for state tax purposes and may result in adverse state tax consequences to the account owner or designated beneficiary.

 CRC# 3970561 11/2024