There are three primary methods for educational savings:
Educations Savings Account (ESA)
Section 529 Plan
The taxable account is the least preferred method as the gains may be taxed each year and an eventual sale may lead to paying capital gains taxes.
Education Savings Account (ESA):
Education Savings Accounts (ESA) grow tax-deferred and subsequent distributions are tax free for qualified expenses. However, ESAs have limits to the annual contributions allowed ( as of 2019, $2,000 per year per beneficiary) as well as income limits for contributors. ESAs can be used for elementary and secondary expenses in addition to post-secondary education expenses.
Section 529 Plans:
Section 529 Plans are sponsored by individual states. Assets grow tax-deferred and subsequent distributions are tax-free for qualified expenses (K-12 and post-secondary). There are no income limitations and each state may or may not have tax incentives for their program. The Commonwealth of Virginia allows for a $4,000 state income tax deduction for each account per year.
Most Section 529 state college savings plans allow parents, grandparents, other relatives, and friends to contribute to a child's higher education fund. Grandparents can set up and manage accounts in the same manner as parents. The account owner makes decisions concerning pre-paying tuition or choosing investment options, and retains ownership of the contract or account until it is used to pay the child's college expenses.
What needs to be done before starting an account?
First is to research the various plans currently available. There are many options available, and each plan is unique. Savers should look for the investment strategies, tax benefits and other incentives that best suit their needs and those of the beneficiary. Often, a person's home state will offer a plan with advantages that other plans do not have.
What about state prepaid tuition programs?
The prepaid programs offered by individual states vary greatly. Virginia's prepaid program has some very serious limitations that need to be considered before making a decision. Also, prepaid tuition programs pay for tuition only, which is approximately half of the total cost of college.