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New Baby? Consider An Education Savings Plan

Sure, some people make $500,000 a year, but the vast majority of us do not, and your children’s and grandchildren’s college education could impose a financial burden.  Your 50s and 60s could become a time of terrible stress unless you do a few things right in your 20s, 30s, 40s, or are lucky enough to have grandparents who can help you out.

Parents and grandparents should consider setting up Education Savings Accounts as soon as a new child is born. Education Savings Accounts and Qualified Tuition Programs, including 529 Plans, are given special tax treatment under federal law.  Over a long period, tax-free compounding turbocharges gains.  Uncle Sam gives you tax-free growth and tax-free withdrawals because the money must be used to pay for tuition and books — not room and board, by the way. 

Keep in mind, grandparents get a special benefit.  Grandparents can pay for a child’s education expenses and it does not count against the annual gift exclusion.  To be clear, in 2015, the exclusion enables each grandparent to give each grandchild $14,000, and neither the child nor the grandparent would owe any tax on that transfer of wealth, and that exclusion is not reduced additional gifts directly made by paying a grandchild’s qualified education expenses. 

In early 2015, President Obama floated a proposal to tax 529 Education Savings Plans but it was shot down fast.  This tax break is likely to be one the government will have difficulty eliminating anytime soon.  It’s silly not to use it.

When a new child is born and a 30-year-old mother or father put away $5,000 in an education savings plan, here’s what happens.  Assuming a 6% average annual return before taxes and a 25% average annual tax rate, investing in taxable bond funds results in about $12,000 of savings after 20 years. 

Investing the $5,000 in stock funds for 20 years that average a 6% return annually give provides a better result, $13,000. Why do stocks returning 6% do better than bonds returning 6%?  Because stock gains 15% are taxed at the capital gains rate, which is more favorable than the 25% tax rate owed on income generated by the bond portfolio.  And we are conservatively assuming a buy and hold strategy in which just 10% of the stock portfolio is sold and replaced annually. 

But the big tax advantage comes from investing the $5,000 in an Education Savings Account for the same 20-year period at the same 6%, resulting in more than $17,000 of savings for your college student.  The difference is substantial. And if the parents or grandparents make annual contributions to the Education Savings Account, the effects would be compounded. 

If you need help setting up an educational savings plan and following through on a long-term plan, please let us know.

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