College tuition costs

Deducting college expenses

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Prepaid tuition (529) plans

College savings (529) plans

Using UGMA/UTMA accounts

Loans & interest deductions

Qualifying for student aid

Tax credits for education

Education savings bonds

Education Savings Accounts

Other IRAs & 401(k) plans

Room-and-board options

Grandparents & other sponsors

Prepaid tuition (529) plans

Several states sponsor prepaid tuition plans to pay for your child's or grandchild's college tuition in advance. Prepaid tuition plans, together with college savings plans, are also called Section 529 plans for the section of tax code that governs them.

Section 529 plans allow private institutions to set up Section 529 plans as long as they meet the same qualifications as public institutions. Beginning in 2002, distributions to pay for all qualified higher education expenses became tax-free for plans that are sponsored by public institutions. For plans sponsored by private institutions, tax-free distributions began in 2004.

Prepaid tuition plans let parents or grandparents hedge, or lock in, a future number of college credits or tuition-years for a beneficiary at an in-state college or university. The opportunity to hedge lets parents and grandparents eliminate uncertainty of tuition inflation.

Terms and conditions of prepaid tuition plans vary. While prepaid tuition plans allow investors from other states to participate, many plans offer tax breaks for in-state residents. In addition, if a beneficiary decides to attend an out-of-state school, the terms of using prepayments vary from plan to plan.

In addition to tax-free distributions for qualified higher-education expenses, Section 529 plans offer the following advantages:

  • Tax-deferred growth of contributions. While you pay for tuition with after-tax dollars, the earnings of your payments grow tax-deferred until the beneficiary begins college. At that time, the child begins to take distributions as he or she uses up the pre-paid tuition. The tax law allows for tax-free distributions for qualified expenses.

  • Control of the account. Section 529 plans keep you in charge of the financial decisions that affect use of the money. This includes retaining the right to change beneficiaries. In comparison, an UGMA or UTMA account becomes the property of the beneficiary when he or she reaches 18 or 21, depending on the state's definition of majority age.

  • Front-loading. For 2021, you can give as much as $75,000 in a single year ($150,000 if married and filing jointly) to a Section 529 plan. That's five times the amount you can give in a year to a beneficiary as a gift and not have to pay gift taxes. By "front-loading" your investment, your account grows to a larger amount sooner. In general, a one-time contribution of $75,000 rules out additional tax-free gifts to the same beneficiary for another five years.

  • Favorable weighting in calculating financial aid. Since Section 529 plans are considered your assets, the weight assigned to those savings is lower when calculating financial aid eligibility for the first year of your child's college education. In subsequent years, the amount the student received in the first year could affect financial aid eligibility.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.

Next, we'll take a look at college savings plans, the other type of Section 529 plans.

Next Topic: College savings (529) plans
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