Saving for college can seem like a daunting task these days, with significant price differences between public in-state schools and private universities, and a large number of complex college savings choices.
Parents wishing to set aside funds for their children’s education have multiple options available to them, but understanding the options and determining the best path can be challenging. This paper seeks to summarize some of the more popular college savings choices.
Section 529 Plans
529 Plans are one of the most commonly used college savings vehicles. Funds grow tax-deferred, and withdrawals are tax-free, if used for qualified education expenses. If funds are not depleted, the account can remain open, and the beneficiary can be changed to another family member. These assets are considered to be those of the parent for the purposes of financial aid, if the parent is the custodian of the account. There are two types of Section 529 Plans to choose from:
Prepaid Tuition Plans
These plans allow the purchase of college tuition “units” at the current tuition rate (subject to a premium), and then participate in the growth of the tuition cost over the time the funds are in the plan. This essentially allows the account owner to lock in current tuition rates. Units can be used for tuition only (not room and board or other expenses). The value of the plan units increase with the price of tuition, so they are not subject to investment risk. In Washington state the prepaid tuition plan is called Guaranteed Education Tuition, or “GET.”
College Savings Plans
College Savings Plans are similar to a 401k, where the return is based on the return of the investments in the individual’s 529 account. Contributions can be made by anyone, and are considered gifts. Individuals can contribute up to $15,000 per person in 2018 without triggering any gift tax. Most 529 College Savings Plans have a lifetime contribution limit of between $235,000 and $500,000, which vary by plan. In the past, only post-secondary educa-tion expenses were considered qualified expenses, however, the recently passed tax reform bill now allows for distributions of up to $10,000 per student, per year, for qualified elemen-tary and secondary education expenses.
The Uniform Transfers to Minors Act (UTMA) allows parents or other adults to open an account on behalf of a minor, over which he or she will remain custodian until the child reaches the age of majority in his or her state of residence. Contributions can be made by anyone, and are considered an irrevocable gift to the child. Funds can be withdrawn at any time, to be used for any expenses relating to the child. When the child reaches the age of majority, full control of the assets transfer to the child. These assets are considered to be the child’s for the purposes of financial aid. Those utilizing these accounts should be cognizant of the potential for the so-called “Kiddie Tax,” meaning that earnings over a certain level may be taxed at the parents’ tax rate, rather than the child’s.
Parents under the age of 59 ½ can withdraw IRA funds without penalty, if they are used for qualified education expenses. For those over age 59 ½, there are no restrictions related to IRA withdrawals. To utilize this strategy, the withdrawal must be made in the same calendar year in which the expenses are incurred, and the amount of the withdrawal cannot exceed the adjusted qualified education expenses (actual expenses, less any tax-free educational assistance received). Distributions from traditional IRA accounts, while not subject to the 10% penalty for owners under age 59 ½, are still subject to ordinary income tax. Distributions from Roth IRA accounts are tax-free, provided the funds have been held in the account for at least 5 years, and withdrawals do not exceed contributions. Any earnings withdrawn from a Roth IRA account will be taxable. Assets held in IRA accounts are not included for the purposes of financial aid.
Coverdell Education Savings Accounts can also be called “Education IRAs.” Funds are invested, and grow tax-deferred. Withdrawals are tax-free if they are used for qualified education expenses. These funds can be used for elementary and secondary education expenses, as well as for post-secondary expenses. Either the account owner or the student can be in control of the account, depending on how the account is established. These accounts limit contributions to a maximum of $2,000 per year from all sources, and are only available to those with a Modified Adjusted Gross Income of less than $110,000 for individuals, and $220,000 for married couples filing jointly
Direct Tuition Payments
In some cases, parents or grandparents may wish to pay the educational institution directly, rather than invest funds or gift to the child. This can be a beneficial strategy, as it avoids the annual gift exclusion limits imposed for gifts to individuals. In order to avoid any potential gift tax, payments must be made directly to the institution, and can be for tuition only. Payments for room & board, books or supplies may still be considered a gift to the child for tax purposes.
Determining which savings vehicle or combination of savings vehicles are best for you can be challenging. Your Freestone Client Advisor can help you choose the option that is right for you, and can run an analysis to estimate college costs for your child or children. We can then use this information to determine how much you need to save each year to meet that expense need, and monitor the plan to ensure you are on track to meet your goal.
Important Disclosures: Nothing in this document is intended to provide, and you should not rely upon it for, accounting, legal, tax, healthcare or investment advice or recommendations. We are not making any specific recommendations regarding any investment or education savings strategy, and you should not make any investment or education savings decisions based on the information in this document. The intention of this document is educational and it is intended only to discuss a few limited aspects of education savings in general terms. This document is not a comprehensive or complete summary of considerations regarding education savings strategies. Each individual is in a different situation and has different items to address, and the options in this document are not appropriate for everyone. Please consult your Freestone client advisor regarding options specific to your needs.