Planning for the cost of higher education is a hotly debated topic. It is always difficult to plan for an expense that may or may not occur and that may be large or small depending on the type of education that is needed. How can you plan for so many unknowns? There is good news; you have options. Chances are that one, or a combination of them, will help you meet your financial needs and the educational needs of your child. What follows is a high-level introduction of common college savings vehicles to consider.
529 college savings plans
Offered by states and some educational institutions, these plans allow you to save significant amounts for a child’s college costs. You can participate in 529 plans offered by your state or offered by other states. Before you choose an out-of-state plan, make sure you understand any tax-benefits offered by your home state plan. More than 30 states offer some form of a tax deduction for 529 plan contributions.
Contributions to 529 plans are where this savings option really shines. You can make small monthly contributions of almost any dollar amount, but most plans allow for total contributions that are in the hundreds of thousands of dollars. There is also flexibility in who can contribute to an account. Nearly anyone can make contributions to an account, including aunts, uncles, grandparents, and friends. Grandparents can start their own 529 plan for grandchildren. In fact, anyone can set up a 529 plan on behalf of anyone. You can even establish one for yourself.
529 plans commonly feature a range of investment options that you may use to protect or grow your college savings, from conservative funds to aggressive growth funds. Many offer glide path funds, which become more conservative as the student approaches college-age.
529 College Savings Plans come with attractive tax benefits. Earnings from 529 plans are exempt from federal tax and generally exempt from state tax when withdrawn, so long as they are used to pay for qualified education expenses. Over time, the tax-free nature of the growth can be very meaningful. However, these accounts should only be used for college savings. Any growth that isn’t used on qualified expenses may result in taxes and penalties.
Thanks to the federal tax reforms passed in 2017, up to $10,000 of 529 plan funds per year may now be used to pay qualified K-12 tuition costs. The rule is plan-dependent; not all 529 Plans have adopted it.
Note, 529 Plans may seem simple on the surface, but the rules are nuanced and can become complicated. Before opening a 529 account, we suggest speaking with a Certified Financial Planner™ Professional (CFP®).
Single filers with modified adjusted gross incomes (MAGIs) of $95,000 or less and joint filers with MAGIs of $190,000 or less can contribute up to $2,000 into these accounts annually, which typically offer more investment options than 529 plans. Money saved and invested in a Coverdell ESA can be used for college or K-12 education expenses.
Contributions to Coverdell ESAs aren’t tax deductible, but the accounts enjoy tax-deferred growth, and withdrawals are tax free, so long as they are used for qualified education expenses. Contributions may be made until the account beneficiary turns 18. The money must be withdrawn when the beneficiary turns 30, or taxes and penalties will occur.
UGMA & UTMA accounts
These all-purpose savings and investment accounts are often used to save for college. When you put money in the account, you are making an irrevocable gift to your child. It cannot be undone, and the money must be used exclusively for the benefit of the minor. The custodian (usually the person contributing to the account) manages the assets until the child reaches the age of adulthood, as determined by each state’s rules (typically age 18 or 21). At that point, the child becomes the owner of the account and can use the UGMA or UTMA funds to pay for anything they choose.
UGMA/UTMA accounts have special tax rules which may make them beneficial, especially for smaller accounts. They are more flexible in their use than 529 accounts, as the funds are not required to be used for college. However, that flexibility is offset by the requirement to turn the account over to the beneficiary at the age of majority. We suggest having a plan in place for the money in the account long before the child becomes an adult.
Whole life insurance
If you have a permanent life insurance policy with cash value (like a whole life or universal life policy), you can take a loan from (or even cash out of) the policy to meet college costs. Should you fail to repay the loan balance, the policy’s death benefit will be lower. If you choose to cash out a policy, be sure to understand the tax impact of doing so. Growth in the cash value above what you’ve paid into the policy may result in taxes.
A Word about Financial Aid
A good plan for saving for college must include an analysis of the ability for you or your child to qualify for financial aid. Each of these accounts has a different impact on financial aid. Used incorrectly, they may have negative impacts on financial aid eligibility.
Planning for college requires some time and commitment, but the payoff can be significant. With proper planning, the outcome can provide meaningful benefits, from access to a better education to less out-of-pocket costs to better tax efficiency.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.