Saving for College: Surveying Some Options

Planning

June 15, 2018
Planning

When it
comes to saving for college, there are two words you should take to heart:

Start … Early.

College is
expensive.

While
starting early is ideal, it does not matter if your child is a newborn, eight
years old, or even a teenager, it is never too late to put a plan in place.

According
to
, the following figures represent the average annual cost of college
(tuition, fees, and room and board only) for the 2017-2018 school year:

Believe it
or not, these averages are understated. They exclude items such as personal
costs, travel expenses, text books, and other supplies. Based on personal
experience, if your child goes to a reasonably well-known school, the figure above for private four-year colleges is low.

In
addition, costs are likely to keep rising. From 2007-08 through 2017-18,
published in-state tuition and fees for public four-year institutions increased
by an average of
beyond inflation.
This compares to average annual increases of 4.0% and 4.4% in the prior two
decades. This rate is slightly higher than for private institutions. Between
2006-07 and 2016-17, tuition and fees increased by only
at private
institutions (3.6% in 2017-18).

Parents
generally want their children to have the option to go to the school of their
choice. However, we must also be realistic about what we can and cannot afford.
Being forced to leave school for
, as I did, is
hard.

Saving
money for college can help make the cost a little easier to bear. In addition,
students can receive need- and/or merit-based financial aid. They can also
qualify for several different loan programs. Working over the summer as well as
during the school year are other options.

The
question is: What is the best way to save for a college education? There are
different types of accounts we can use. Which one(s) we choose can make a
difference, especially when filing for financial aid.

529 Plans

A 529 plan
is a tax-advantaged savings plan designed to encourage saving for future
education costs. Legally known as “qualified tuition plans,” 529 plans are
sponsored by states, state agencies, or educational institutions and are
authorized by Section 529 of the Internal Revenue Code.

There are
two types of 529 plans:

·        
Education Savings Plans

·        
Prepaid Tuition Plans

All 50
states, as well as the District of Columbia, sponsor at least one type of 529
plan. In addition, a group of private colleges and universities as well as
state institutions sponsor prepaid tuition plans.

Education Savings
Plan

Education
savings plans let a saver open an investment account to save for the
beneficiary’s future qualified education expenses. Withdrawals from these
accounts can be used at any college or university; sometimes at non-U.S.
colleges and universities, too. Education savings plans can also be used to help
pay for tuition at any public, private, or religious elementary or secondary
school. (See “Qualified Educational Expenses below for additional information.)

After-tax
dollars deposited in 529 plan accounts grow free from federal income tax,
allowing them to potentially achieve higher rates of compound growth. Depending
on your state of residence, contributions to such accounts may also provide
state tax benefits.

If the
money is used to pay for qualified education expenses for those attending
school at least half time, withdrawals are tax-free. Funds can be used at
virtually any accredited college or university in the U.S. as well as some
foreign schools. In addition, 529 plans can also be used for vocational and
trade schools. You can see a list of eligible schools on the
. In short, a 529 plan is not just a college savings vehicle. It can
be considered an education savings vehicle.

Although
all education savings plans are sponsored by state governments, a few have
residency requirements for the saver and/or beneficiary. Investments in
education savings plans are not guaranteed by state governments. Similarly, no
federal guarantees are provided for investments in mutual funds and ETFs.
Investments in some principal-protected bank products may be insured by the
FDIC. Accordingly, as with most investments, investments in education savings
plans may not make any money. In fact, you could lose some or all money
invested.

Qualified
Educational Expenses

In addition
to expenses such as tuition, books, and room and board, as of 2018, the term
“qualified higher education expense” includes up to $10,000 in annual expenses
for tuition associated with enrollment or attendance at an elementary school,
or secondary public, private, or religious school. You must, however, check
with the school’s state 529 plan to see if it permits this option.

Contribution Limits

In general,
you can currently contribute up to $15,000 annually ($30,000 if married)
without incurring gift tax. You can contribute a lump sum of $75,000 to one or
more 529 college savings plans in a single year ($150,000 if married) without
incurring gift tax. The IRS views such amount as an annual $15,000 ($30,000 if
married) gift over five years. Contributing more money on behalf of the same
child during those five years triggers gift tax.

States may
also cap how much you can accumulate in a 529 account. Limits vary by state,
ranging from $
. This amount
represents what the state believes to be the full cost of attending an
expensive undergraduate and graduate school, including textbooks and room and
board. If your plan’s balance is close to the limit you need not worry about
future earnings in the account pushing it over. The funds can remain in the
account without penalty, but the family will not be able to make future
contributions until, or unless, a market drop causes it to fall below the state
cap.

One word of
caution about leaving funds in a 529 account to pay for graduate school: Funds
in a 529 account must be disbursed, or transferred to another family member,
before the beneficiary turns 30. You can even make yourself the beneficiary for
educational purposes – even if, for example, it is for education related to a
hobby.

Prepaid Tuition
Plans

If you
expect your child will attend a public school in your state, an alternate 529
plan that allows you to prepay tomorrow’s college tuition at today’s prices may
make sense. A 529 prepaid tuition plan provides certain guarantees for tuition
and certain expenses at any in-state public school. Some prepaid plans cover
tuition, fees, and room and board; others only cover tuition and fees.

If your
child decides to attend an out-of-state private school, state prepaid tuition
plans can be transferred toward these costlier options; however, they usually
only pay the average in-state tuition cost.

In
addition, there are currently
private colleges that
offer a
. This plan
allows you to save money on the cost of attending a nationwide group of private
colleges and universities (Stanford to Duke, Princeton to University of
Chicago, MIT to Rice, and hundreds more). Regardless of the rate at which
tuition increases over the years, or how volatile stock financial markets may
be, you lock in current rates that can be used at any of the participating
colleges and universities. (Unfortunately, participating in this program does
not benefit – or guarantee – your child’s chance of being admitted into any
participating school.)

The Private
College 529 Plan is not an investment. It allows you to pay for tomorrow’s
tuition at today’s prices in the form of
. They are like conventional 529 accounts in that you name a
beneficiary when you open the account. However, you do not select a college or
university until your student enrolls. Increases in the account’s value as well
as distributions are federal tax free.

The Private
College 529 is the only 529 plan that is not run by a state. Instead, the
participating colleges and universities own the Plan. They also guarantee the
tuition you prepay.

In general,
prepaid plans offer certainty of college costs with a related trade-off. They
limit your child’s flexibility when choosing which school to attend. Some
states offer transferability of benefits; some offer a potential for partial
refunds if the beneficiary (or an eligible sibling) does not attend college.

Account ownership

One of the
most important features of a 529 plan is its ownership. The account belongs to
you. Your child may be the beneficiary, but you remain in charge of the money,
which is managed by a fund manager assigned by the state. The importance of
account ownership will be discussed in more detail in our next blog, which will
discuss financial aid.

In general,
college savings plans allow you to choose from a variety of predetermined asset
allocation portfolios that range from conservative to aggressive, based on
historic volatility and potential return.

What if your child
receives a scholarship?

If your
child receives a scholarship, and you decide to withdraw funds from a 529
account rather than change beneficiaries, you will owe ordinary income taxes on
any earnings generated by your contributions. If the withdrawal exceeds the
amount of the scholarship, you will have to pay an additional 10% penalty on
earnings for the amount greater than the scholarship. If you withdraw less, the
10% penalty does not apply. Such non-qualified withdrawals may also be subject
to recapture of state tax credits or deductions you received when making contributions.

Impact on federal
and state income taxes

Investing
in a 529 plan may provide special tax benefits. As long as withdrawals from a
529 account are used to cover higher education expenses or tuition for
elementary or secondary schools, earnings in the 529 account are not subject to
federal income tax and, in many cases state income tax. These benefits depend
on the state and the 529 plan. For example, if you live in Northern Baltimore
County, which is where Apprise Wealth Management is located, you can deduct up
to $2,500 annually per child on your state tax return for contributions to the
Maryland 529 plan.

The state
and federal tax laws that affect 529 plans could change. You should make sure
you understand the implications of investing in a 529 plan and consider whether
to consult a tax adviser.

If
withdrawals from a 529 plan account are used for nonqualified purposes, then
federal income tax, a 10% federal tax penalty, and state income tax may be due
on the earnings generated by such accounts. Generation-skipping tax may also
apply to a beneficiary at least two generations below the contributor.

Coverdell Education
Savings Accounts

A Coverdell
Savings Account (ESA) is another special account designed to help pay for your
child’s education. You set up the ESA and choose how to invest the money,
typically on behalf of the child beneficiary.

Like a 529
account, amounts invested in an ESA grow tax free. Since you don’t have to pay
taxes on investment income or capital gains, you can benefit from tax-free
growth. If the money is used to pay for qualified education expenses, withdrawals
are also free from federal tax. Tax-free withdrawals also apply to amounts paid
for qualified elementary and secondary education expenses – regardless of if
the school is public or private, secular, or religious.

The annual
maximum contribution to an ESA is $2,000 per beneficiary – less for higher
earners. If a parent contributes all $2,000, grandparents and other individuals
are not allowed to make additional contributions to the account during the
year. On the other hand, your child can be the beneficiary of both a 529 plan
and an ESA;
you can contribute
money to both accounts in the same year.

If your
child does not attend college, or there is money left in the ESA account after
he or she graduates, the remaining savings can still be used. The account
beneficiary can be changed to another member of the original beneficiary’s
family. The IRS uses a broad definition of the term “family member” – it can
include everyone from siblings and parents to step-siblings and in-laws.

Using money
withdrawn from an ESA for non-qualified expenses, means any untaxed earnings
are taxable to the beneficiary. A 10% federal tax penalty is also payable.

Coverdell vs. 529
Accounts

You have
more flexibility in terms of how you invest money in an ESA as you are not
limited by the options presented in the state-sponsored 529 plan. However,
unlike 529 plans, an income eligibility limit and a relatively low limit on
contributions apply. The contribution limit applies at the beneficiary level as
well, making it difficult to contribute considerable sums to an ESA.

Custodial Accounts

If you
desire to save money for college expenses that are not covered by an ESA or 529
plan, a custodial account is another option. This approach allows you to take
advantage of the gift tax exclusion and control the way the money is invested
and spent while your child is a minor. On the other hand, once your child
reaches a certain age (generally 18, 21, or 25 years depending on where you
live) the money becomes his or hers. In addition, investment income in
custodial accounts may trigger the kiddie tax (meaning it can be taxed at a
higher rate).

Parents
cannot simply transfer assets to their minor children, but instead must
transfer the assets to a trust. The most common trust for a minor is known as a
custodial account. A custodial account is typically designated either an UGMA
(Uniform Gift to Minors Act) or an UTMA (Uniform Transfer to Minors Act)
account, depending on where you live. When money is deposited into a custodial
account, a gift is given or funds are transferred to the recipient. You can
open a custodial account at virtually any brokerage or financial institution.
The minimum to open such an account usually ranges from $500 to $2,000.

A significant
drawback associated with contributing money to a custodial account is it only gives
you broad control over how the money is invested and spent while your child is
a minor. The gift tax exclusion means the money must be given as an
irrevocable, “no strings attached” gift. In other words, neither the donor nor
the custodian can place any restrictions on the use of the money when the minor
reaches the age of majority. At that time, the child can use the money for any
purpose whatsoever without requiring the custodian’s permission, so there is no
requirement that the child use the money for his or her education. In addition,
since the UGMA/UTMA accounts are in the name of a single child, the funds are
not transferrable to another beneficiary.

When putting
money in a custodial account, keep this in mind. You and your child might both agree
that the money should be used for college. However, once your child reaches the
age of majority, she has control over the account. She can use the money for
anything she wants. Since she thinks you will still pay for her education, she could
decide to buy an expensive new car. Now her college funds are at least
partially depleted. She could also decide she does not want to go to college.
You no longer can transfer the money to another family member. You should also
keep in mind that many states may allow you to specify an earlier or later date
to turn over the account’s assets to your child, as long as that date does not
interfere with your state’s age of majority rules.

Because
your child owns the assets in an UGMA/UTMA account, they are weighed more heavily
than parental assets when determining financial aid. As a result, according to
, custodial
accounts only make sense if you are certain your child will not need financial
aid.

There also
some lesser known disadvantages associated with UGMA/UTMA accounts:

·        
If the Giftor serves as custodian and passes away before the account
matures, the assets in the account may be included among the custodian’s assets
for estate tax purposes.

·        
If the child dies before receiving the assets in the account, the
accounts are dealt with according to the laws of the state, which may not be in
your favor.

Taxation of
Custodial Accounts

The income from
a custodial account must be reported on the child’s tax return and is taxed at
the child’s rate. As a result, amounts in custodial accounts are also subject
to the kiddie tax rules. These rules were changed by the Tax Cuts and Jobs Act
of 2018. It should be noted that the rules are currently supposed to revert to
the previous tax regime after 2025. In general, most parents of children with
modest unearned income (for example, interest, dividends, capital gains) will
pay the same or less taxes under the current kiddie tax rules, unless they do
not have any taxable income. But, parents of children with significant unearned
income from UGMAs/UTMAs may pay higher taxes because the parents’ tax rate is
no longer used under the new law.

The
following tables summarize the tax treatment of custodial accounts under both
old and new tax law:

How custodial
accounts were taxed in 2017*

*These rules applied to any child under 19 as
well as full-time college students under the age of 24, unless the student’s
earned income was greater than one-half of their support. Earned income from a
job or self-employment is not subject to the kiddie tax.

How custodial
accounts are taxed in 2018*

As noted, after 2025, the kiddie tax rules revert
to those in place prior to 2018.

529 Plans and
Coverdell Education Savings Accounts Versus Custodial Accounts

529 plans
and ESAs give you much more control over how funds in an account are used,
including the option to change beneficiaries if the need arises. The only
limitation is that the funds must be used for education expenses in order to
benefit from their preferential tax treatment.

On the
other hand, there may be certain circumstance where depositing money in a
custodial account makes sense. Money in a custodial account can supplement what
is saved in a 529 or ESA for your child’s education. For example, it could be
used for college expenses other than qualified expenses such as travel,
sorority dues, or car repairs. However, it might be easier (and cheaper) to
keep such amounts in an account in your name and disburse them to your child at
the appropriate time.

Roth IRAs

A
tax-advantaged Roth IRA can be used as a combined retirement account and
educational savings vehicle. This approach offers numerous benefits and some
flexibility. Because your after-tax contributions grow tax-free, your account’s
growth potential is maximized. You also can invest in a wider variety of assets
than you would in a 529 account. Withdrawals from Roth accounts for qualified
education expenses are allowed penalty free, but they will generally be
included as income in determining financial aid eligibility.

A
meaningful advantage of using a Roth IRA as part of your college savings
approach is that if your child is fortunate enough to be awarded meaningful
scholarship money, you can keep the amounts in your Roth account for your
retirement. On the other hand, using your account to pay for qualified
educational expenses can have a material adverse impact on your ability to stay
on track for retirement. The amount you can contribute to a Roth account on an
annual basis is also limited. Income limitations may apply as well.

Summary

In

the options, ownership is a primary consideration. If you select an
UTMA/UGMA account, when your child reaches the age of majority, the account is
theirs. They can use it for anything they want (e.g., an expensive vacation, a
new car, etc.) Plus, it counts more for financial aid purposes. There are
other ways to save for a college education, but these are the most common ones.
While an ESA account has some advantages, the contribution and income limits
make it harder to use. A 529 plan is likely the best account type for college
savings.

If you would like to talk to us about your options
for college savings, please fill out our 
, and we will be in
touch. In our next post, we will talk more about financial aid.

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