By Haddon Libby
Amongst the thoughts of many parents and grandparents is how to pay for a child or grandchild’s educational expenses. In a time when higher education is more necessary than ever in building one’s career, so too are the costs. As a result, many parents and grandparents think about the best way to save up for higher education.
To understand the way to set-up the best educational account for your needs, let’s review the three basic ways to set-up an account:
529 Plan: These accounts are set-up with after-tax monies. When monies are withdrawn for educational purposes, none of the earnings or appreciation are taxed.
Coverdell Education Savings Account: Contributions are limited to no more than $2,000 per year for each beneficiary up to the age of 18. To use these accounts, your income must be less than $110,000 a year if you are a single tax filer or $220,000 if you are married.
Your 401k or IRA: Monies contributed to your 401k or IRA are not taxed until withdrawn. When these funds are used for educational expenses, the 10% penalty on early withdrawals does not apply. Monies withdrawn are subject to income tax as no tax has ever been paid on earnings used to fund the account.
Let’s assume that you want to set-aside $1,000 that is withdrawn for education in seven years. To keep the analysis simple, let’s avoiding future contributions in years 2 through 6.
As a 529 plan and a Coverdell ESA are essentially the same, go with the Coverdell ESA if you can. With the Coverdell, you can invest in anything that your brokerage account allows. In my experience, 529 plans have higher costs and weaker investment options. Coverdell ESAs can only be used by those with adjusted gross incomes of less than $110,000 for single taxpayers and $220,000 for couples filing jointly.
When making the decision as to whether to put the money in an educational account or your retirement account, the final decision comes down to your tax rate.
If you pay a tax rate of 25% or more, the 529 is your best choice. If you have a tax rate that is under 25%, contributing to your 401k/IRA is the better choice. The reason why you might use a Coverdell over an IRA is because you want to separate education and retirement funds. You also might do it if your tax rate is low today, but you expect it to be higher in seven years.
Simply put, the more concerned you are with keeping your taxes down, the more you need accounts like your 401k, IRA, 529 or Coverdell.
Armed with this knowledge, all you need to know is your tax rate. Do not worry if you do not know – virtually no one does.
To find your tax rate, find your last state and federal tax returns. I’ll use the 2019 Form 1040 from the IRS and Form 540 from the State of California to help guide you this.
Federal taxes can be calculated by looking at the first two pages of your tax return. Line 8b is your adjusted gross income and line 16 is your total tax. If you divide total tax by your adjusted gross income, you have your federal tax rate. Let’s pretend that this number comes out to 11.1%.
To get your state tax rate, line 19 is your taxable income and line 35 are your taxes. Let’s pretend that this number comes out to 3.9%.
If you add your federal and state tax rates together, we get your tax rate which is 15%. At a 15% tax rate, your best option is to keep the money in your retirement account unless you think that you will be paying a much higher tax rate down the road. If your tax rate is 25% or higher, 529s and Coverdells produce the best results.
Need help understanding any of this? Drop me a note and I’d love to help. I can be reached at Hlibby@WinslowDrake.com.
Haddon Libby is the Founder and Managing Partner of Winslow Drake Investment Management. For more information, visit www.WinslowDrake.com.