Options for College Planning
Planning for a child or grandchild’s education is one of the most important goals of many. It can also be one of the most challenging. We will be describing different options for saving for this important goal and as complex as it will seem, realize even this list is not comprehensive. As you begin to understand your options, we encourage you to explore them more deeply with an advisor versed in college planning strategies and which one(s) are best suited for you.
What are the options?
Using equity from property: One possibility is to take money out of hard assets such as property. I may have equity built up in my primary residence or other property that I could draw upon to fund college expenses or any expenses for that matter. The primary concerns with this plan is that we don’t know for sure if there will be any equity in the future to draw on. If there is equity available, I don’t know what the cost will be. This changes over time, but it is safe to say, if your current loan originated in the past few years and you refinance or take a second loan in the future, it will be more expensive. Another risk is that there may be some sort of natural disaster that would prevent you from taking any sort of loan at all. In general, this is probably not going to be the best plan for funding college.
Government Bonds: The interest on Series I bonds and Series EE bonds issued after December 31, 1989 are tax free if used to pay for qualified higher education expenses or to roll over into a section 529 plan. There are limits on how much per year can be used and income limit phase outs that should be reviewed with a tax professional if this is a tool that is being considered. The positive side of this option is that the security is backed by the full faith of the U.S. Government, so it is very safe. The downside is, that the interest earned is very low and likely not keeping up with the rising cost of a higher education. Therefore, in a low interest rate environment this is probably not the best option.
UTMA or UGMA: Another tool that could be used is the Uniform Gift to Minors Act (UMGA) or the more common Uniform Transfer to Minors Act (UTMA). It is important to remember that when money is placed into these accounts it is irrevocable. These are trust accounts that are very easy to establish without the cost of hiring an attorney and drafting a trust. Until the age of majority (18 or 21 years old in most cases) the account is controlled by an adult, the custodian. In some cases this control can extend to age 25. The custodian can use those assets in the account for nearly any purpose as long as the funds are used for the minor’s benefit. When the minor obtains age of majority they become owner of the account and can use the money for any purpose including but not limited to higher education. The amount that can be contributed to this account is unlimited, however, any amount over the annual (Gift Tax Exclusion) may be taxable to the donor.
The custodian of the account must be an adult. There is no limit to the number of accounts that are set up for that minor. For example, each parent, grandparents etc. can set up a separate account for the same minor and each transfer/gift the maximum allowed amount each year. While the account can be used for a variety of purposes, its primary perceived benefit is its ability to shelter a certain amount of the capital gains within the account from taxation. The current rule is that the first $1,000 of income is tax-free, the second $1,000 is taxed at the minor's rate (typically zero or 15%), and the amount over $2,000 is taxed at the parent's rate.
These accounts are great if the true intention is to gift money to a child for any purpose. Because the money is the child’s at the age of majority, the person gifting the money needs to understand that the money could be used for things other than originally intended. Sometimes, the small tax savings don’t outweigh having control of the assets. Another concern with these accounts is that the assets are treated as an asset of the minor for financial aid. Which means it will reduce what aid is available by more than if the account were treated as an asset of the parents.
IRA: Another option is to use an IRA to fund these expenses. The same rules apply to contributions and whether they are tax deductible base on having a qualified plan at work and the amount of income earned will determine the deductibility of the contribution. The earnings grow tax deferred and if used for a qualified higher expenses for the owner or a dependent can use them without penalties. The withdrawal, over any basis, will still be taxed as income. One thing to remember about this option is that there are no loans, scholarships or financial aid for retirement so retirement accounts may be better served for retirement.
ROTH IRA: The above caution applies to this method as well. However if the plan is to use a ROTH IRA for funding qualified higher education expenses then it can be an effective tool. Keep in mind that not everyone can contribute to a ROTH IRA. The contributions are based on income limits and if you can contribute, you may want to use the money to help your own retirement instead of funding college. Why is it an effective tool? Like some other accounts there are no tax deductions on contributions but the earnings will grow tax deferred and withdrawals are tax free if it is either a return of the basis or if the five year rule is satisfied for earnings. Also, if the child does not go to college or we don’t need the money for that goal it is already in a retirement account. Once again we would like to emphasize that these accounts are probably better suited for the retirement.
Cash Value Life Insurance: The tax treatment of life insurance is similar to that of the ROTH IRA noted above. There is generally no deductions for contributions, the cash would accumulate tax deferred and any withdrawals should be a return of contributions followed by loans that would be tax free. There are of course special rules on how much can be contributed and what needs to be done to maintain the favorable tax treatment. Another virtue of this vehicle is that it typically does not show up on financial aid applications and thus does not negatively impact the amount of aid that is available.
The downside of this vehicle is that when planning for a child’s college fund we usually have a time frame of 18 years at the most, before we would need to start accessing the funds. With that time frame it is hard to justify the cost of the insurance inside the plan to take advantage of the tax rules. Someone typically would have to contribute large sums of money to have this be a viable part of the plan.
529 Plans: This is a state sponsored plan designed specifically to help people save for higher education. There are two types of 529 plans: pre-paid tuition plans and college savings plans. Pre-paid tuition plans allow savers to purchase units or credits at various colleges and universities for future tuition. These plans generally cover tuition and mandatory fees only. There are a few plans that may allow add on for room and board. Under this plan there may be age or grade requirement. In addition, there may be a resident of the state requirement for either the student or the owner of the account.
A College savings plan is a trust set up for the benefit of another for the use of higher education. The person designated to receive the benefits is called the “Beneficiary”. The owner of the account is called the “Custodian”. College savings plan covers all qualified higher education expenses including room & board, books and computers (if required). The participant must be of age of majority, however there is no age limit for the beneficiary.
These funds must be used for post high school education, this can include; trade schools, community colleges, universities (public and private). If the funds are not used for education by the initial beneficiary, the named beneficiary can be changed. This can be changed to any family member; sibling, parent, grandparent or even the beneficiary’s child. Subsequent changes can be to a non-relative.
The main advantages are the tax treatment. Plan contributions grow tax-deferred and if used properly for qualified educational expenses the appreciation of the assets can be used income tax free. Some states offer their own tax benefits for residents who use that states plan. Other advantages are how the asset is treated for financial aid purposes. The account is treated as a parental asset and distributions are counted as parent or student income.
The main disadvantage is that these funds can only be used for higher education. Therefore, funds are unavailable for use for non-educational use or educational expenses K – 12. If the funds are used in this manner there will be taxes and penalties imposed.
Coverdell ESA: This is a trust or custodial account like the 529 plan that is designed for the purpose of paying for qualified education. However, with these plans the qualified education includes expenses derived from eligible elementary or secondary schools also (K-12).
Like other plans there is a designated beneficiary for the account. The beneficiary needs to be under the age of 18 for contributions to be allowed into the account, unless the beneficiary is a special needs child. The maximum amount that can be contributed is $2000 for any beneficiary in one year. There can be multiple accounts and multiple contributors, but the most that can go in for any one beneficiary is $2000 total. The account generally needs to be used by the time the beneficiary is 30 years old. The beneficiary can also be transferred to another member of the beneficiary’s family.
There are income limits for contributors. If you earn between $95,000 and $110,000 and are single the amount you could contribute declines in that range and if over $110,000, you cannot contribute. For married couples the income phase out is between $190,000 and $220,000.
The advantages in this plan is very similar to the 529 plan. It is a way to make non-deductible contributions that grow on a tax deferred basis and have the qualified withdrawals (within limits) be tax free. It also has the expanded qualified expenses that can help a parent pay for elementary or high school costs.
The main disadvantages are also similar to the 529 Plan. The account must be used for education purposes only. That is not necessarily a disadvantage if that is the goal for the money, but it does limit the options that may be desirable years after the account is created.
Conclusion: It is understood that this is one of the main financial goals for many. Realizing the complexity and amount of options available it is important to seek advice. That advice should come from a licensed financial consultant and a licensed tax professional. Again, in our discussion we really only touched on the different accounts available and not all of the investment options that would tie into risk tolerances and time frames. We also did not discuss the tax credits and deductions that are available and changing often that a tax professional can help with. We did touch upon how some of the different accounts affect financial aid, but that is usually a deeper conversation also. Chances are that a combination of different accounts is the best plan for most people considering the difficult and sometimes daunting task of funding their child’s education.
The information contained is general in nature and should not be construed as comprehensive financial, tax or legal advice. As with any financial or legal matter consult your qualified securities, tax or legal representative before taking action. ROTH IRA: To qualify for the tax free penalty free withdrawal of earnings, a ROTH IRA must be i place for at least five tax years and the distribution must take place after age 59 1/2 or due to death, disability, or a first time home purchase (up to $10,000 lifetime maximum). Before taking any specific action, be sure to consult with your tax professional. 529 TAX-FREE PROVISIONS: An investor should carefully consider the investment objectives, risks, charges and experiences associated with 529 plans before investing. More information is available in the issuer's official statement which can be obtained from your financial professional. The official statement should be read carefully before investing.
Advisory services provided by TrilogyCapital, Inc,. a Registered Investment Adviser. Separate advisory and securities services may be provided by National Planning Corporation (NPC), a SEC Registered Investment Adviser and broker-dealer. Member FINRA and SIPC. Certain registered representative with NPC are doing business under the name of Trilogy Financial. TrilogyCapital, Inc. and Trilogy Financial are affiliated by common ownership and are separate and unrelated to NPC. Please consult with your representative to confirm, on which company’s behalf services are being provided.