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What college savings plan options are available?

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The average cost of college can be as much as $35,000 a year. Though that may seem daunting, starting to save for college early can make it feel much more manageable.

Several college savings plan options are available. Each offers certain advantages as well as potential tax and financial aid implications. From individual retirement accounts (IRAs) to an education savings account, here's what you need to know about different college savings vehicles.

529 college savings plans

A 529 plan allows you to save for college expenses. The money grows tax-free, and you can withdraw it tax-free to pay for qualified education expenses. It is important to know that the earnings on investments in 529 plans are not guaranteed and can lose value based on market conditions.

These plans are typically administered at the state level, have high contribution limits and may offer a tax deduction, depending on the state. For example, in Massachusetts, you can receive a state tax deduction on up to $2,000 of your contributions to a 529. Massachusetts also has a contribution limit of $500,000.

One of the advantages of a 529 plan is the benefit of tax-free withdrawals if you use the money to cover specific education costs. You can also transfer a 529 plan to eligible family member. Hypothetically, let's say your first child gets a full scholarship to college but you have money sitting in a 529 plan. You can change the beneficiary to your younger child and use the money to pay for that child's college. You could also put the account in your own name or transfer it to another eligible relative.

An important consideration when funding a 529 plan is that it can affect your child's financial aid, especially if the account is in their name. 529s also have limited flexibility. Remember to take into account the possibility of your child getting a full scholarship or having a family member contribute to their higher education costs. Depending on state requirements, you may not be able to use this money for non-education purposes. However, they may still be used to pay for housing expenses. When you use these funds for non-educational costs, there is typically a 10% penalty and income taxes on the earnings within these withdrawals. (This penalty is waived in the event of a death or disability.) If you want more flexibility in paying for college, a brokerage or custodial account may give you more options.

Coverdell education savings account

Like a 529 plan, a Coverdell education savings account is a type of trust or custodial account that allows you to save money and invest to cover future college costs. Contributions and earnings can grow tax-free, and you can withdraw them tax-free to pay for qualified education expenses. Otherwise, any nonqualified withdrawals will be subject to a 10% tax penalty on earnings.

However, one of the biggest differences between a 529 plan and Coverdell is that a Coverdell account has lower contribution limits, and your family must be below a certain income threshold to be eligible to contribute to a Coverdell. Currently, the maximum contribution limit is $2,000 per year. If you're a single tax filer with an annual income of over $110,000 or a joint filer with an annual income over $220,000, you can't contribute to a Coverdell.

If you are eligible for a Coverdell, it's important to know that, similar to many of the other college savings plan options, this account will impact financial aid. Also, you can't hold onto this account forever—any amount remaining in the account must be distributed to a beneficiary within 30 days of their 30th birthday, unless the recipient is considered a special needs beneficiary. The beneficiary then can choose to transfer this account to another family member to avoid potential taxes on earnings and a 10% penalty.

Roth and traditional IRAs

Roth and traditional IRAs are typically thought of as strictly for retirement, but they also can be used to pay for college.

A Roth IRA is an account that allows you to save after-tax dollars. The money can grow tax-free in the account, and contributions and earnings can be withdrawn tax and penalty-free once the account holder reaches age 59 and a half and has owned the account for at least five years (you can withdraw contributions penalty-free from a Roth IRA at any time). A traditional IRA allows you to save pre-tax dollars for retirement and, in most cases, receive a tax deduction on your contributions. The money in the account can grow tax-deferred. However, when you become eligible for qualified withdrawals at age 59 and half, you'll have to pay income taxes on the amount you withdraw.

If you withdraw from an Traditional IRA before 59½, you'd have to pay a 10% penalty on your withdrawals along with income taxes. However, the IRS allows account holders to take distributions from a Roth or traditional IRA for qualified education expenses without penalty. However, you'll still pay income taxes if part of your withdrawal includes any earnings from the account. Unless you are 59½ withdrawing from a Roth IRA you've owned for over five years—then the earnings are tax- and penalty-free.

You can take a qualified education distribution from an IRA to pay education expenses for you, your spouse, children or grandchildren. Qualified education expenses include tuition, fees, books, supplies and equipment necessary for attendance at any college, university, vocational school or other postsecondary educational institution eligible to participate in the U.S. Department of Education's student aid programs.

Using money from an IRA to pay for college has certain advantages and disadvantages. The main advantage is the penalty-free withdrawals for qualified education expenses, which can give your family additional financial flexibility if the student doesn't receive enough financial aid or scholarships to pay for college. This also may help your student avoid loans and debt after they graduate.

However, there are downsides to using an IRA to cover college costs. For one, the withdrawal will reduce your savings earmarked for retirement and you'll potentially miss out on the tax-free or tax-deferred growth on the amount you withdraw. You'll likely also pay income taxes on any earnings you withdraw, and you have to make sure you fully understand what specific education expenses qualify or you could face the 10% penalty. Another issue is that your withdrawals, even if qualified, may count as income if your family files the Free Application for Federal Student Aid (FAFSA). The withdrawal will count as part of your total income and could affect your expected family contribution, which is the total amount a school expects your family to contribute to the student's college expenses. It also could affect the potential financial aid your student receives. The FAFSA requires families to report income from the two years prior to when they request financial aid, so the timing of your IRA withdrawals is critical.

Keep all these factors in mind before choosing to use your IRA to pay for college, especially if there are other college savings plan options that may offer more flexibility.

General investment accounts

A general investment account, or a brokerage account, is among one of many college savings plan options.

With this account, you have more freedom to choose how you invest—whether it's in a mutual fund, index fund or individual stocks and bonds. Unlike retirement accounts, there is no cap on how much you can contribute every year, and you have more flexibility to withdraw whenever you want and for whatever purpose you choose, including paying for college.

However, there are tax implications depending on how long you've held assets in the account. You may have to pay short- or long-term capital gains taxes on any gains you withdraw. If you sell any assets in your account that you've had for less than a year, you'll have to pay the short-term rate, which is the same as your ordinary income tax rate. Long-term capital gains tax applies to assets you've held for at least a year. These taxes are generally lower and range from 0% to 20%, depending on your individual or joint income.

Using a general investment account to pay for college expenses comes with its own pros and cons. Similar to an IRA, you'll potentially sacrifice tax-deferred growth on the amount you withdraw. Another consideration is that the amount you withdraw will count as income and factor into your expected family contribution and financial aid package. Currently, 5.64% of parents' assets count toward expected family contributions, so if you have $50,000 in a brokerage account, you will be expected to pay $2,820 of this money toward a student's college expenses.

However, the upside of using a general investment account is that you don't have to worry about qualified education expenses. If you want to use the money to buy the student a car to get around campus or to or from their internship, you can do that. It doesn't just have to be to pay for tuition, fees or books.

Custodial accounts

There are two main types of custodial accounts: a Uniform Gift to Minors Act (UGMA) account and a Uniform Transfer to Minors Act (UTMA) account.

The main difference between UGMA and UTMA accounts is the type of assets you can hold in each. You can hold basically any type of asset in an UTMA, including real estate, collectibles, fine art, royalties and more. With an UGMA, your holdings are limited to cash, insurance policies and investment assets like stocks, bonds or mutual funds.

Each account has one designated custodian (typically a parent) and one designated minor beneficiary. However, the major drawback of custodial accounts is that the assets in these accounts are irrevocable, meaning the contributions made to the account belong to the beneficiary. You can't take them back or make withdrawals.

Some of the biggest benefits of using an UTMA or UGMA to pay for college is that there's no limit on the amount you can contribute or no income eligibility limit. These accounts also get favorable tax treatment, since the deposits are considered gifts and therefore tax-free under the annual gift exclusion. Beneficiaries who are under 19 years old, or under 24 and a full-time student, and whose taxable income is below $1,150 aren't subject to taxes. After that, the next $1,150 in unearned income is taxed at the child's income tax rate (any income in the account over $2,300 is taxed at the custodian's federal income tax rate). You also can use this account for any purpose—not just to pay for college—so it's much more flexible than an IRA, 529 or Coverdell college savings account.

However, custodial accounts also can affect financial aid. Currently, up to 20% of a child's assets count toward the expected family contribution. Since a child is the owner of the UTMA or UGMA, the assets in this account likely will affect your family's out-of-pocket costs for college more than if the same amount of money were held in an account you owned as their parent. UGMA and UTMA accounts also must be terminated when the beneficiary reaches age 18 and 21, respectively, and the assets in the account must be distributed to the beneficiary. Keep this in mind if you intend to use this account as a college savings vehicle because once your child reaches these age thresholds, you can't control what they do with the assets in the account.

Permanent life insurance and trusts

Permanent life insurance and trusts are two non-traditional college savings plan options.

Permanent life insurance features what's known as cash value. When you have a policy, a portion of your premiums are invested and may grow tax-deferred over time. You have the flexibility to withdraw your policy's cash value while you're still alive for any purpose. You can make withdrawals as a loan or as a straight distribution, but doing so will affect the death benefit your beneficiaries receive after you pass away. However, you can choose to pay back the loan, which would avoid this.

With a trust, you can structure it any way you choose, including requiring that distributions only be used for education. A trust allows you to have more control over assets contained within the trust, how they are invested and how they are distributed. You can establish qualified transfers that generally do not affect beneficiaries' annual or lifetime exclusion, which is the maximum amount you can transfer to someone else as a gift. Depending on how much you gift a child or family member, how you structure the trust, and the beneficiary's access to the trust, it may affect financial aid in varying ways. For example, the value of the trust may restrict the child's eligibility for need-based financial aid altogether.

Getting a head start on saving for college

Whether you choose to use an IRA, 529 plan, general investment account or permanent life insurance to save for college will depend on your savings goals and the level of financial flexibility your family requires. A financial advisor can help you create a sustainable plan for your family's unique circumstances and goals.

Contribution limits, tax consequences and rules around qualified distributions vary by each account. If you decide to use an IRA or general investment account as a college savings vehicle, you also have to weigh how this will affect future retirement savings. We all want to give students every opportunity possible. These college savings plan options allow you to start early, gradually build your family's savings to cover college costs, and empower you to give a student one of the best gifts imaginable—a great education.

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Loans and surrenders will decrease the death proceeds and the value available to pay insurance costs which may cause the contract to terminate without value. Surrenders may generate an income tax liability and charges may apply. A significant taxable event can occur if a contract terminates with outstanding debt. Contact your tax advisor for further details. Loaned values may accumulate at a lower rate than unloaned values.

529 college savings plans are offered through a brokerage arrangement with Thrivent Investment Management Inc. They are not guaranteed or insured by the FDIC and may lose value. Consider the investment objectives, risks, charges, and expenses associated before investing. Read the issuers official statement carefully for additional information before investing. Investigate possible state tax benefits that may be available based on the state sponsor of the plan, the residency of the account owner, and the account beneficiary. Consult with a tax professional to analyze all tax implications prior to investing.

While Thrivent does not provide specific legal or tax advice, we can partner with you and your tax professional or attorney.
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