College Savings

Budgeting for Your New Baby

College Savings, Personal Finance, Taxes / By

Babies bring joy and excitement. They also bring substantial adjustments to the family budget! According to U.S. News and World Report, after adjusting for inflation, it costs about $267,233 in 2021 dollars to raise a baby to age 18 (based on previously published Bureau of Labor Statistics data). That’s a daunting number, to be sure. Fortunately, there are some things you can do to pacify the challenge.

Check Your Insurance

Life and disability insurance are critical. Life insurance provides financial protection if an income-earner in your family dies. Term insurance can be a cost-effective option. It offers protection for a specific period, such as 20 years (at which point many children will be relatively self-sufficient, and the loss of income less harmful). Of course, you’ll also need to ensure that your will names a guardian to look after your children in case of your death while they’re still minors.

Disability insurance provides financial protection if a breadwinner becomes disabled and no longer can earn a living. While some employers offer disability insurance, the policies often don’t provide enough income to cover all expenses. And Social Security disability benefits might not offer the protection you expect. For instance, to obtain the benefits, the breadwinner typically must be unable to work at any job. So, consider purchasing your own policy that will pay if you can’t continue in your current job. The distinction might make a difference.

Review Tax Breaks

Eligible parents can receive a valuable Child Tax Credit. And if you pay a caregiver to watch your baby so you can work, you may be able to claim the dependent care credit. For 2021, depending on your income, this can be up to 50% of eligible childcare expenses, up to $8,000 for one child, or $16,000 for two or more. The caregiver typically can’t be a dependent, your spouse or a parent of the child.

Another option is a dependent care Flexible Spending Account (FSA). This is an employer-sponsored program that allows parents to set aside up to $10,500 (for 2021) pretax annually (up to $5,250 if you’re married and file separately) to cover qualified childcare expenses. It’s important to note that you can’t use both the credit and the FSA for the same expenses.

Start Saving for College Early

The sooner you start saving for your baby’s education, the more you can leverage the value of compounding. If you save $200 per month starting at your baby’s birth and earn a 6% return, you’ll have nearly $78,000 in 18 years!

One of the best options, potentially, is a Section 529 education savings plan. It allows you to save for college expenses, as well as K-12 tuition expenses. Contributions aren’t tax-deductible for federal purposes, but many states offer tax benefits. Withdrawals used for qualified education expenses (limited to $10,000 per year for K-12 tuition) aren’t subject to federal income tax, and typically not subject to state income tax.

Get Expert Advice

Whether you have a baby on the way or your family expanded earlier in the year, it’s important to make sure you’re taking the right steps to ensure your child’s financial security. Maggart can offer advice to help you evaluate various options and maximize your tax savings.

How the Consolidated Appropriations Act Affects Education Funding

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The Consolidated Appropriations Act (CAA), signed into law late last year, contains a multitude of provisions that may affect individuals. For example, if you’re planning to fund a college education or in the midst of paying for one, the CAA covers two important areas:

1. Student Loans 

The CARES Act temporarily halted collections on defaulted loans, suspended loan payments and reduced the interest rate to zero through September 30, 2020. Subsequent executive branch actions extended this relief through January 31, 2021. The CAA leaves in place that expiration date.

Also under the CARES Act, employers can provide up to $5,250 annually toward employee student loan payments on a tax-free basis before January 1, 2021. The payment can be made to the employee or the lender. The CAA extends the exclusion through 2025. The longer term may make employers more willing to offer this benefit.

2. Tax Credits 

Qualified taxpayers generally can claim an education tax break with the American Opportunity credit and the Lifetime Learning credit. Previously, though, the two credits were subject to different income phaseout rules, with the American Opportunity credit available at a greater modified adjusted gross income (MAGI) than the Lifetime Learning credit. In addition, before the new law, there was a higher education expense deduction for qualified tuition and related expenses that taxpayers could opt to claim instead of the credits.

The CAA applies the higher American Opportunity credit phaseouts to the Lifetime Learning credit, effective for tax years beginning after December 31, 2020. The credits will phase out beginning at MAGIs of $80,000 for single filers and ending at $90,000. For joint filers, they will begin to phase out at MAGIs of $160,000 and disappear at $180,000. The new law also eliminates the higher education expense deduction for 2021 and beyond.

529s vs. Roth IRAs, which Is Better for College Savings?

College Savings, Personal Finance / By

Many people assume that a 529 plan is the ideal college savings tool, but other vehicles can help parents save for college expenses, too. Take the Roth IRA, for example. Whether you should use one or the other (or both) depends on several factors, including how much you intend to contribute and how you’ll use the earnings.

Plan Snapshots

A 529 plan allows participants to make substantial nondeductible contributions — up to hundreds of thousands of dollars, depending on the plan and state limits. The funds grow tax-free, and there’s no tax on withdrawals, provided they’re used for “qualified higher education expenses” such as tuition, fees, books, computers, and room and board. Other qualified expenses include up to $10,000 of primary or secondary school tuition per student per year and, new under last year’s SECURE Act, up to $10,000 of student loans per beneficiary. If you use the funds for other purposes, you’ll generally be subject to income taxes and a 10% penalty on the earnings portion. Some 529 plans are also eligible for state tax breaks.

Roth IRA contributions also are nondeductible and grow tax-free. And you can withdraw those contributions anytime, tax-free and penalty-free, for any purpose. Qualified distributions of earnings — generally, after age 59½ and more than five years after your first contribution — are also tax- and penalty-free.

Advantages & Drawbacks

The main advantages of 529 plans are generous contribution limits and the ability to accept contributions from relatives or friends. Roth IRAs, on the other hand, are subject to annual contribution limits of currently $6,000 ($7,000 if you’re 50 or older). So, even if you and your spouse each set up Roth IRAs when your child is born, the most you’ll be able to contribute over 18 years is $216,000 (not taking into account any future inflation increases to the contribution limit). Additional drawbacks are that you must have earned income at least equal to the contribution, and you can’t contribute to a Roth IRA if your adjusted gross income exceeds certain limits.

Funds in a 529 plan that aren’t used for qualified education expenses will eventually trigger taxes and penalties when they’re withdrawn. However, with a Roth IRA, you can use contributions, as well as qualified distributions of earnings, for any purpose without triggering taxes or penalties. This includes items that wouldn’t be qualified expenses under a 529 plan, such as a car or off-campus housing expenses that exceed the college’s room and board allowance. Plus, if you don’t need all your Roth IRA funds for college expenses, you can leave them in the account indefinitely.

Consider Your Financial Goals

Before selecting a plan, consider your overall financial, retirement, and estate planning goals. Our firm can help.

Year-End Tax & Financial To-Do List for Individuals

College Savings, Medical Expenses, Personal Finance, Retirement, Taxes / By

With the dawn of the new year on the near horizon, here’s a quick list of tax and financial to-dos you should address before this year ends:

Check your Flexible Spending Account (FSA) balance. 

If you have an FSA for health care expenses, you need to incur qualifying expenses by December 31 to use up these funds or you’ll potentially lose them. (Some plans allow you to carry over up to $500 to the following year or give you a 2½-month grace period to incur qualifying expenses.) Use expiring FSA funds to pay for eyeglasses, dental work or eligible drugs or health products.

Max out tax-advantaged savings. 

Reduce your income by contributing to traditional IRAs, employer-sponsored retirement plans or Health Savings Accounts to the extent you’re eligible. (Certain vehicles, including traditional and SEP IRAs, allow you to deduct contributions on your return if they’re made by April 15th.)

Take required minimum distributions (RMDs). 

If you’ve reached age 70½, you generally must take RMDs from IRAs or qualified employer-sponsored retirement plans before the end of the year to avoid a 50% penalty. For instance, if you turned 70½ in 2019, you had until April 1, 2020, to take your first RMD. But keep in mind that, if you defer your first distribution, you’ll have to take two next year.

Consider a qualified charitable distribution (QCD). 

If you’re 70½ or older and charitably inclined, a QCD allows you to transfer up to $100,000 tax-free directly from your IRA to a qualified charity and to apply the amount toward your RMD. This is a big advantage if you wouldn’t otherwise qualify for a charitable deduction (because you don’t itemize, for example).

Use it or lose it. 

Make the most of annual limits that don’t carry over from year to year, even if doing so won’t provide an income tax deduction. For example, if gift and estate taxes are a concern, make annual exclusion gifts up to $15,000 per recipient. If you have a Coverdell Education Savings Account, contribute the maximum amount you’re allowed.

Contribute to a Section 529 plan. 

Sec. 529 prepaid tuition or college savings plans aren’t subject to federal annual contribution limits and don’t provide a federal income tax deduction. But contributions may entitle you to a state income tax deduction (depending on your state and plan).

Review withholding. 

The IRS cautions that people with more complex tax situations face the possibility of having their income taxes under-withheld because of changes under the Tax Cuts and Jobs Act. Use its withholding estimator (available here) to review your situation.

If it looks like you could face underpayment penalties, increase withholding from your or your spouse’s wages for the remainder of the year. (Withholding, unlike estimated tax payments, is treated as if it were paid evenly over the year.)

For assistance with these and other year-end planning ideas, please contact the team at Maggart.