The 2019 school year is in the books. At Scotts Valley High, 188 students graduated with 176 heading to college. At San Lorenzo Valley High, 136 graduated, and 118 are college-bound.
Those heading off to college – along with their parents and maybe other relatives – will face the challenge of paying for it. And the state of California is considering a tax deduction that would help.
First, let’s look at two popular ways to save for college, 529 plans and Coverdells:
529 plan: Allows you to invest much larger amounts than Coverdells. Most 529s limit the investments to a family of mutual funds. Your money grows tax deferred and can be withdrawn tax free as long as it is used to pay college tuition or other “qualifying” expenses.
The donor names a child as beneficiary but can later switch to a related beneficiary or reclaim the funds for him or herself. Any distribution that isn’t used for education will subject the donor to income tax plus a 10% penalty on the earnings portion of the distribution.
Coverdell Education Savings Account: Similar to a 529, but contributions are limited to $2,000 a year and must stop at age 18. A donor with income that is too high can’t contribute. Money can be invested in individual stocks or bonds, not just mutual funds. You can use a Coverdell not only to pay for college but also tuition for kindergarten through 12th grade.
Coverdell donors have the flexibility of switching the beneficiary to an eligible family member, but unlike a 529, the donor can’t reclaim the money. Any withdrawal not used for education will subject the donor to income tax plus a 10% penalty on the earnings.
The 2017 federal tax overhaul allowed up to $10,000 to be withdrawn tax free from a 529 to pay K-12 tuition. But California has not signed off on the change, so a 529 withdrawal to pay K-12 expenses is subject to state income taxes on the earnings plus a 2.5% penalty, according to Mark Kantrowitz of Savingforcollege.com.
Meanwhile, California may offer a new break. State Treasurer Fiona Ma is pushing a bill in the Assembly that would give families a deduction of up to $10,000 if they contribute to the state-managed 529 plan known as ScholarShare, the Sacramento Bee reports.
In 34 other states, taxpayers can get that kind of deduction for contributing to a 529. California is one of eight states that have a state income tax but don’t offer a tax deduction or credit.
California lawmakers have raised the idea in the past but shot it down over concerns that it would mostly benefit the rich. Ma argues it would help middle-income Californians who lost deductions in the federal tax overhaul.
Two other ways to save for college are simply to set aside money in the parent’s name - which offers complete control but no tax advantage - or to give money to a child in the form of a Uniform Transfer to Minors Account (UTMA), where growth is taxed at the child’s low tax bracket.
A UTMA belongs to the child, so the money can be used for any expense that benefits the child, like a car, not just for education. But money in a UTMA can reduce the amount of financial aid a student can qualify for.
Money in Coverdells, 529s or in parents’ names are treated equally in financial aid qualifying, and provide an advantage over UTMAs, Kantrowitz said.
Mark Rosenberg is a financial consultant in Scotts Valley with Western International Securities, a member of FINRA and SIPC. He can be reached at 831-439-9910 or firstname.lastname@example.org