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. Below are a few options.
One possibility is to take money out of hard assets such as property. You may have equity built up in you primary residence or other property that you could draw upon to fund college expenses. The concerns with this plan is that we don’t know if there will be any equity in the future to draw on. If there is equity available, you don’t know what the cost will be. 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. In general, this is probably not going to be the best plan for funding college.
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 by a tax professional. The positive side of this option is that the security is backed by the U.S. Government. The downside is, that the interest earned is very low. Therefore, in a low-interest rate environment, this is probably not the best option.
Another tool that could be used is the Uniform Gift to Minors Act (UMGA) or the more common Uniform Transfer to Minors Act (UTMA), 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 as long as the funds are used for the minor’s benefit. When the minor obtains the age of majority they become the 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 can be set up for that minor. 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. 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.
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 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.
The above caution applies to this method as well, but if you 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 you 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.
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 special rules on how much can be contributed and what needs to be done to maintain the favorable tax treatment. It also does not typically show up on financial aid applications so it does not negatively impact the amount of aid that is available.
The downside 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.
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. 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.
This is a trust or custodial account 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).
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 anyone 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 that the account must be used for education purposes only.
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.