The option to front-load funding makes a tax-deferred college savings plan is a great way to avoid taxes on the future growth of funds earmarked for higher-education expenses. We project that the taxes avoided over a 10-year savings horizon could pay for a full year of college.
How It Works
Saving for a child’s or grandchild’s college or graduate school tuition is in some ways a more daunting challenge than saving for retirement. The costs are impossible to control, and the time you have to save is shorter—typically, just 18 years. Fortunately, there is a tax-advantaged way to save for education.
Contributions to tax-deferred college savings plans, commonly referred to as 529 plans, grow free of federal tax, and earnings can be withdrawn tax free as long as the funds are used for qualified higher-education expenses. These expenses include tuition, fees, books, supplies and equipment, and special-needs services required for enrollment or attendance at an eligible educational institution, as well as room and board, for students attending at least half time.
The program allows taxpayers to front-load five years of annual exclusion gifts, and thus give up to $70,000 in one year ($140,000 for a married couple) per beneficiary.
Contributions to a tax-deferred college savings plan for a child beneficiary are considered gifts, but qualify for the gift-tax annual exclusion, which is now $14,000 per beneficiary and will increase with inflation. Taxpayers can make gifts of up to $14,000 ($28,000 for a married couple) per year per beneficiary to an account for any number of individuals, such as children and grandchildren.
Another program, called a Coverdell Education Savings Account, is also available, but only to couples with less than $220,000 in annual income and individuals with less than $110,000 in annual income. It has much lower contribution limits.
Quantifying the Benefits
Let’s assume that a married couple expects their child, currently in second grade, to start college in 10 years. They have just begun to save for her college tuition and want to look at a few options:
- Save $28,000 per year for the next 10 years in a taxable account
- Save the same amount in a tax-deferred plan over 10 years
- Use $140,000 from a recent bonus to front-load a tax-deferred plan with five years of contributions today and again at the beginning of year six
These amounts may seem outlandish, but the cost of attending an elite private college is now about $65,000 a year and is rising faster than inflation. The benefits of smaller contributions are scalable. All else being equal, if you contribute 10% as much ($6,500) each year, the outcome would be 10% as large.
The Display below illustrates the advantage of a tax-deferred plan. We project that the taxes avoided by saving each year would increase the plan’s account value to $296,900, or $15,400 more than the $281,500 in a taxable account, in today’s dollars in the median case, represented by the diamond within each bar.
When the contributions to the plan re front-loaded, the additional years of tax-free growth bring the median value of the plan to $330,100 in today’s dollars, or $48,600 more than in the taxable account. To the extent that parents or grandparents begin saving earlier in a child’s life, the tax-free growth potential is even greater—enough to pay for a full year of college tuition at an elite university.
Many investors fear front-loading their contributions to a plan. “What if the market plunges in the first year?” they ask. “Wouldn’t I be better off spreading out the contributions, so that I’d be investing at lower prices after a market drop?”
Our answer is no. Our worst projected outcomes for a plan with front-loaded contributions are still higher than our worst projected outcomes for the plan with regular contributions for 10 years, as the display also shows.
When considering a front-loaded contribution, think about its timing. Toward the end of the year, it may make more sense for a taxpayer to make an annual exclusion gift for the current year and plan to front-load five years of contributions in January of the next year. That way, more money can begin growing tax free more quickly.
Bernstein does not provide tax, legal or accounting advice. Please consult with your legal or tax advisor regarding your specific situation.
The Bernstein Wealth Forecasting SystemSM uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.
Tara Thompson Popernik, CFA, CFP, is Director of Research for the Wealth Planning and Analysis Group at Bernstein Global Wealth Management, a unit of AllianceBernstein.