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U.S. Expat College Savings Plan Options
August 2, 2022
The cost of education in the U.S. inflates at average rate of about 6% annually. Understanding the various investment choices available to save and afford college education is crucial for parents who want to prepare for this major future expense. College savings can be a critical element of a long-term wealth building strategy with careful planning. To properly prepare for their children’s education, U.S. citizens living abroad can utilize certain tax-efficient investing strategies to save for their children’s college education. We will also cover some of the challenges U.S. expats encounter when trying to take advantage of these unique opportunities.
529 Savings Plan
Investors can make contributions to a particular account designated for future educational costs through a 529 education savings plan. State governments or private schools and universities may create 529 schemes. Washington, D.C., and every state possesses a minimum of one 529 education savings plan. U.S. expats may not be regarded as residents of any one state, but they are nevertheless eligible to open a 529 savings plan since no state imposes residency requirements on holders of 529 accounts.
These 529 savings plans accept after-tax contributions from parents, other family members, and even friends, as contributions to these plans are not tax deductible. Until the funds are used to cover the costs of higher education, the growth on the assets are tax-free provided it is used for “qualified” educational expenses such as tuition, books, room and board, computers, etc. Travel, insurance, cars, application and test costs, and loan installments are examples of non-qualified expenses. Taking money out of the plan to use at an ineligible institution or non-qualified expenses may result in income tax due as well as a 10% penalty.
Any qualified college in the U.S. as well as certain eligible colleges abroad may qualify for distributions from 529 education savings accounts. Tax amendments now permit withdrawals from 529 plans for U.S. K–12 school tuition (but only tuition) of up to $10,000 per year. It is still uncertain if 529 savings can be used for K–12 education abroad.
State tax benefits, which often provide an incentive to use the home state plan, are irrelevant if an expat is not liable for state taxes. This enables U.S. citizens abroad to select a 529 plan based entirely on investment merit.
The use of a 529 savings plan has a lot more benefits. Large donations up to a certain limit can be made to a 529 plan without triggering gift taxes in the United States. A 529 plan’s financial resources can be used in a variety of ways. The investor may shift the beneficiary to another close relative or distribute money to themselves for permissible costs if the beneficiary chooses not to pursue higher education.
However, U.S. expats should also pay close attention to the local tax ramifications in their country of domicile (if any) when investing in 529 plans.
Coverdell Education Savings Account
Coverdell Education Savings Accounts, also known as ESAs (formerly known as “Education IRAs”), are another way to save for college expenses. Donors may make a maximum yearly contribution of $2,000 per minor. Contributions to a Coverdell ESA may be made by parents, grandparents, other family members, friends, and the kid for whom the account is formed; however, the ability to make contributions phases out if the contributor’s Adjusted Gross Income (AGI) exceeds $220,000 on a joint return ($110,000 for single filers). U.S. expats can open a Coverdell ESA account even if they are not in the United States.
Like a 529 plan, Coverdell donations are not eligible for a tax deduction; however, income and gains are not subject to taxes. If distributions are used for eligible educational costs, such as college, the distributions are tax-free. While 529 funds may be used for K-12 tuition only, Coverdell money can be used for both K-12 tuition and expenses (i.e., books and supplies). The funds must also be withdrawn once the beneficiary reaches the age of 30 if they do not go to college, and any income may be subject to tax and penalties. Unused money may be transferred tax-free to another beneficiary’s Coverdell ESA who is under 30 years of age.
College Saving Strategies Using Traditional Investment Accounts
For many American expats, utilizing conventional investment or retirement accounts for education expenses might also be a great alternative besides special tax-advantaged accounts.
When combined with inexpensive and tax-efficient investment strategies, a taxable brokerage account can be an effective savings tool for a college education. Investors can reduce capital gains and take advantage of the decreased long-term capital gains rate by starting their investments early. In some situations, this may be the ideal choice for U.S. expats who are concerned about the possible tax repercussions of using a college savings account created in and for the United States. In any event, it is typically preferable to use a brokerage account than employing a local country’s college savings plan that has ambiguous tax repercussions in the United States.
The 10% early withdrawal penalty that generally occurs to withdrawals from an IRA before the age of 59.5 does not apply when funds are distributed from an IRA (including a Roth IRA) to cover higher education expenses. However, the same tax laws for regular and Roth IRA distributions still apply to withdrawals. Retirement accounts may be utilized in some circumstances (and depending on bilateral tax treaties) to alleviate some tax issues caused by 529 plans in the nation of domicile.
Special Considerations for U.S. Expats: Country-of-Residence Tax Considerations
U.S. expats have access to all the aforementioned college savings plans. However, the tax-advantaged nature of Coverdell ESAs or 529 savings plans is usually not recognized by tax treaties between the United States and other countries. Considering investment gains and payouts may be subject to local tax rules in your country of domicile, using a U.S. education savings plan may be a detrimental approach to save for educational costs if not done properly.
When filing U.S. tax returns, college savings accounts in your country of domicile may also prove detrimental. Several countries also provide college savings plans, but the tax benefits offered by these accounts are not acknowledged in the United States and can easily become toxic investments for U.S. expats, especially if deemed as a Passive Foreign Income Company (PFIC).
Leveraging Investment Returns Through College Savings Accounts
U.S. expat parents are recommended to begin saving for college expenditures as early as possible. It can make sense to put the riskier component into a 529 savings plan when considered in the context of a bigger investment portfolio. There will not be a capital gains tax when such appreciated assets are withdrawn from a 529 plan or Coverdell ESA fund to finance higher education costs. By using these unique accounts, investors can take full advantage of tax deferral and tax-free withdrawals.
Disclaimer
- The information provided is for educational purposes only and does not constitute personal financial, tax or investment advice and should not be relied on as such. It does not take into consideration any investor’s particular investment objectives, strategies, time horizon, and tax or legal status. Abacus Wealth International (AWI) does not provide tax or legal advice. Please consult a tax or legal professional for corresponding tax and legal advice.
- All material and content have been obtained from sources believed to be reliable. AWI does not guarantee the accuracy of the information provided and shall not be held liable for decisions based on the foregoing information.
- All examples of graphs, financial products and historical returns contained in the foregoing material are for illustration and educational purposes only and shall not be deemed as financial advice or recommendation. Past performance is not indicative of any future investment returns.