CKBlog: Financial Planning
Monday, December 01, 2014
Understanding College Savings Plans: Let’s Hit the Books
by Steve Haberstroh, Partner
A common topic amongst my friends these days is saving for college; and it can be incredibly daunting to ponder. Those who are most honest with me admit that they are very scared. “With tuition rates continuing to rise, how in the world will I be able to pay for little Johnny in 15 years? Itâ€™s like another monthly mortgage payment! Where do I begin?”
Don’t freeze and don’t panic. You can either pray for a lacrosse scholarship, or you can create a plan and get to work. Your term papers never wrote themselves, calculus tests were never taken by ignoring the topic. Saving for college is no different: it requires work. So let’s hit the books.
In this post, I will cover some common and effective savings programs for parents. By no means are they the ONLY options but they are sound choices to help you get started. I also touch upon some strategies for grandparents as many of my parents’ friends are equally curious as to how they can help.
But the first step is to take a deep breath ... you can do this—it may require a bit of help from a tutor, but you can do this!
Strange name, huh? Not exactly the most marketable name but considering the author of this plan, it makes sense. The name comes from The Internal Revenue Code Section 529, as amended in 1996.
As the IRS explains, a 529 plan is “A plan operated by a state or educational institution, with tax advantages and potentially other incentives to make it easier to save for college and other post-secondary training for a designated beneficiary, such as a child or grandchild.” Excited yet?
It goes on, “Earnings are not subject to federal tax and generally not subject to state tax when used for qualified education expenses of the designated beneficiary, such as tuition, fees, books as well as room and board.” Ok, now we’re talking. But how does this work in practice?
- Do research on the pros and cons of each 529 plan to determine the right plan for you and your family. A good place to start is www.savingforcollege.com
- Open a 529 plan/account and determine how you would like to fund the account
- Choose the investments offered in the plan (usually mutual funds, index funds, ETFs or age-based funds)
- Keep an eye on the investments and make adjustments as you or your advisor see fit
- Eventually, pull money out of the plan tax free, provided it is used for post secondary education expenses (college level)
As noted above, these qualified expenses can extend from tuition to books and even laptops. You can even use these funds for many universities outside of the United States. As always, I recommend speaking with your tax advisor if you have specific tax questions regarding 529 plans.
- Flexible funding options (automatic or lump sum options)
- Potential tax deductions based on contributions (each state is different)
- Investments grow tax free provided they ultimately are used for college level expenses
- Assets are withdrawn tax free provided they are used for college level expenses
- Interesting estate planning strategies for grandparents or other relatives (more on this later)
- In order to get the tax benefits, 529 plan assets must be used for college expenses. If your child decides to not attend college or does not need these funds for college expenses, when you pull money out of the plan you will be subjected to taxes on gains as well as a 10% penalty on any earnings. (It should be noted that you can use the funds for a sibling of the child or even a first cousin of the child without incurring a penalty. Under current code, you may also avoid the 10% penalty if your child earns a scholarship. However, investment gains are subject to tax regardless of scholarship.)
- In terms of qualifying for financial aid, 529 plans funded by a parent are no different than assets held in a parent’s account
- Unfortunately, the tax benefits of 529 assets do not apply to fund K-12 expenses even if your child attends a private school—more on this later.
There are many 529 plans to choose from and in fact, each state offers their own. Certain states will allow you to deduct a portion of your contribution per year on your tax return provided you live in the state of the 529 plan you have enrolled in—again, check with your tax advisor.
It is important to note that just because you use a Connecticut Plan, for example, it does not mean your child must attend a university in Connecticut—you will be free to use these assets to fund the expenses of the college of Johnny’s choice. And just because you live in Connecticut does not mean you can’t use another state’s plan (each state’s 529 plan carries different fees and investment options so a plan outside of your state may be a better option for you).
In addition to doing research online at sites like www.savingforcollege.com, I would recommend you speak to a qualified financial advisor about the pros and cons of each of the plans. I like to look at plans with the most investment options and lowest management fees. I would also recommend you take a hard look at your state’s plan if they offer deductions for your contributions.
Look at the 529 plan as a tax-advantaged way to save for college. And if you start early enough and select solid investments, the power of compounding returns can make a huge impact.
Another marketing marvel! Depending on the state, these acronyms are short for Uniform Transfer to Minors Act or Uniform Gift to Minors Act. These are custodial accounts which allow you to save on behalf of your child for education or any other purpose that benefits the child (other than parental obligations such as food, clothing, shelter).
Your parents may have set one of these up for you growing up; mine did. They were popular in the past as it allowed parents to move investment income out of their tax bracket and into the child’s lower tax bracket. This is still the genesis of using UTMA/UGMAs but the IRS recently made changes to make this strategy less effective as a tax management solution. Commonly known as the “Kiddie Tax,” the IRS currently (2014) stipulates that the first $1,000.00 of the UTMA/UGMA’s unearned income (interest, dividends, capital gains) is tax exempt, and the second $1,000.00 is to be taxed at the child’s tax rate. However, anything over $2,000.00 will be taxed at the parents’ tax bracket. So, the tax benefits of using this strategy have diminished in recent years.
Another potential disadvantage is that at the age of majority (which varies by state but is generally 18 or 21), the child is entitled to full access of the funds. That’s right, if Johnny knows about his UTMA/UGMA, is 21 and wants to treat his entire fraternity to a week in Jamaica, it’s his money to do so. Now, for most, that scenario is unlikely, but it is worth thinking about. If this might be a concern for you, consult with an estate planner as there may be alternatives that allow for some control when your child reaches the age of majority.
Lastly, if your goal is to maximize financial aid, this is not the best strategy. Currently, assets held in an UTMA/UGMA account are counted as the student’s asset and therefore has a significant negative impact on the ability to get financial aid. For very wealthy and/or very high income earners who wouldn’t otherwise qualify for financial aid, this may be a moot point. But for everyone else, it is something to consider.
Despite these potential drawbacks, the UTMA/UGMA can still be a useful tool. For one, since it can be held as a brokerage account, you have more investment options than those afforded to you in a 529 plan. As custodian, you can choose cash, stocks, bonds, mutual funds, index funds, ETFs and you can make changes as you see fit for your child. For some this may create more work and trepidation. But for savvy investors or those working with a professional, the benefits of flexibility are attractive.
- Potential tax savings over keeping parent’s assets in their own account (although not substantial due to “Kiddie Tax”)
- Flexible funding options (periodic, lump sum)
- Can invest across many different security types and make changes as parent sees fit
- Can be used for expenses which benefit the child (e.g. secondary education, summer camps, travel)
- Potential Tax Savings have been reduced
- Gifts are irrevocable
- Child has full access to funds at age of majority (varies by state but is generally 18 or 21)
- Negative impact on financial aid
As is the case with most savings vehicles, there are pros and cons to using a UTMA/UGMA. The added flexibility will be attractive to some, but the reduction in potential tax benefits has made this vehicle less attractive than it had been in the past.
The Coverdell is similar to a 529 plan in that you contribute after-tax dollars into an account. The investments grow tax deferred and if used for education expenses, the withdrawals are tax free. It differs from the 529 plan in that funds can be used for K-12 schooling and the maximum allowable contribution per child (from all sources including non-family members) is $2,000.00 per year. So, for aggressive savers, or generous grandparents, contributions may be capped quickly. Lastly, the ability to contribute phases out as the contributor’s income reaches certain levels. Current phase-outs begin at $190,000.00 for joint filers and $95,000.00 for single filers.
- Flexible funding options
- Investments grow tax deferred and can be withdrawn tax free for education expenses
- Can be used for K-12
- $2,000.00 annual cap for contributions from all sources
- Income phase outs prohibits high income earners from being able to contribute
So while it is perhaps the most restricted savings vehicle, the main benefits are its tax efficiency and its ability to be used for K-12 expenses.
Savings or Brokerage Account in Parent’s Name
The default savings strategy for most parents is using their own investment account. While it does not offer some of the potential tax benefits mentioned above, many parents prefer the control of managing their own account. Because it is your account, you can invest in the securities you are comfortable with, you can manage taxable events and you can use funds for whatever you see fit.
In my experience, parents are more motivated to save when an account has been established for a specific purpose. So if you don’t use a 529, UGMA/UTMA or Coverdell and you wish to “earmark” funds for education, simply open another brokerage account and segregate it from your other investment accounts. That way you can manage the investment according to when your child might be heading off to school.
Grandparents or other Family Members
Gifts Under $14,000.00 in 2014
Perhaps a family member has offered to write a check or make a contribution towards your child’s education. We can all dream, can’t we? If you want the funds to go directly to Johnny’s UTMA/UGMA, have them make the check out to Johnny but beware that if they do, it is an irrevocable gift so you cannot change your mind later and move UTMA/UGMA assets into a 529 or other account not in Johnny’s name. For most other gifts under $14,000.00, they can make the check out to you and you will transfer funds into the desired account (I assume Johnny trusts you).
We’ve done a lot of work so far, so let’s dream a little more. If said family member is feeling particularly generous, they can gift up to the gift tax annual exclusion amount, currently at $14,000.00 per person per beneficiary. So a contribution up to that amount would work for a 529 contribution, UTMA/UGMA contribution, or a deposit into a parent’s (your) personal account. It would not work for a Coverdell as contributions regardless of source are capped at $2000.00 annually. Imagine that, a $14,000.00 gift!
Gifts Over $14,000.00
Ok, now it’s time to really dream. Suppose a family member is rather wealthy and may have an interest in reducing the assets held in their estate. Let’s also suppose they really like Johnny and have an interest in helping fund his college education. This is most common with grandparents.
Granddad can elect to gift funds into any of the strategies listed above but he will be capped by the $14,000.00 gift tax exclusion amount. But if he is really looking for impact and wants to gift more than $14,000.00, let’s see what a 529 plan will allow him and Grandma to do.
Any 529 contributions would immediately be removed from their taxable estate—for many wealthy families, that is a desired outcome. Not only are the assets removed from their estate, the assets held inside a grandparent-owned 529 plan are currently not included in the calculation to determine a student’s financial aid. Sounds great, doesnâ€™t it?
It gets even better. The IRS has allowed for a special gift tax exclusion permitting a lump sum gift equal to five years worth of the $14,000.00 limit if it is being gifted into a 529 plan ($14,000.00 x 5 = $70,000.00). So in our hypothetical example, both Grandma and Granddad could gift $70,000.00 into a 529 plan for Johnny today for a total of $140,000.00 (provided no other gifts are made during the next 5 years). The funds hit the 529 account, can be invested and ultimately used for college-level expenses without being taxed on any of the gains. Now that’s a gift that keeps on giving!
Of course, this is a very unique situation. But it illustrates the point. If you are working with sound estate planners, CPAs and financial advisors, there are many powerful college saving tools and strategies at your disposal.
2503(c) aka Education Trusts
This strategy also falls under the category of “charitable” grandparent. Grandma and Grandpa make a gift to a trust for little Johnny and can appoint you and your spouse as the trustees. The assets can be invested just like a brokerage account (stocks, bonds, mutual funds, etc.) and are to be used primarily for education. If there are funds left over after all education expenses, the assets have to be distributed to Johnny during his lifetime (or be included in his estate upon passing). If properly structured, this strategy may also take advantage of removing assets from wealthy grandparents’ estate. Please consult with a qualified estate planner if you think this strategy might make sense for your family.
There are many college savings programs out there. Each has its own benefits as well as challenges and should be used as part of your overall financial plan. If you focus too much of your savings on Johnny’s college, he may be supporting you in retirement so make sure you don’t over commit yourself. Remember, you can take a loan out for college but you can’t take a loan out for your retirement.
The trick is to spend the time, do a little research and figure out what is best for you and your family. And get some professional help. Qualified advisors working with your CPA and estate planner can be a powerful combination.
So in conclusion, we read a little, we thought a little, did some number-crunching and even daydreamed a bit. I feel like we’re back at Econ 101!
Now exhale ...