By: Nick Hughes
5/29 - Can you think of a better date to consider various college funding options?
Earlier this year, President Barack Obama in his State of the Union address proposed eliminating some of the tax benefits associated with 529 Plans, a popular college savings plan used by millions of American families. Fortunately, the administration made a quick reversal and surrendered their proposed plan at a time when skyrocketing college costs are placing the goal of a higher education out of reach for more and more households. Let’s take a look at some of the myriad of choices you have when planning for education expenses.
1) 529 Plans – These are one of the most well known college savings vehicles with 48 states and the District of Columbia offering state sponsored plans. They are typically invested in mutual funds and offer tax-deferred growth of earnings and tax-free withdrawals for qualifying college related expenses. (tuition, housing, books, etc.) In addition, several states offer additional tax benefits for in-state residents that utilize the state sponsored plan. One of the potential drawbacks to these plans is that withdrawals used for non-qualified education expenses are subject to a 10% penalty. One caveat to the penalty is for withdrawals of up to the amount in scholarships received. The custodian (usually a parent or grandparent) can change the beneficiary (the intended recipient and current or future student) at any time and maintains control of funds even though they are not counted as part of the custodians estate, making 529 Plans an effective estate planning tool as well. There are no income limitations for contributions and contributions of up to $14,000 per year per beneficiary are available with a 5-year $70,000 lump sum contribution available to those that haven’t made prior year gifts.
2) Coverdell ESA’s (Education Savings Accounts) – These offer the same tax-deferral and tax-free withdrawal of earnings that are associated with 529 Plans but with slightly more flexibility. They can be invested in a broader array of choices besides strictly mutual funds and also can be used for elementary, secondary school, and college expenses. Contributions are much more limited, however, as families earning over $220,000 are not eligible and contributions are limited to $2000 per year per beneficiary. Since Coverdell funds are typically earmarked for private K-12 expenditures, the limitations and shorter time period for growth typically outweigh their benefits.
3) Uniform Trust for Minors Account (UTMA) - UTMA accounts were much more popular before Congress limited some of the tax benefits in 1986. These accounts are established as gifts of cash or securities to a minor and are subject to current gift limits of $14,000 per year. As it stands, the first $2,000 of investment income from these types of accounts get special tax treatment. The first $1000 of income is tax-free with the next subject to the child tax rate of 10%. Any investment income above the $2000 threshold will be taxed at the parent’s capital gains or ordinary income rate. The major potential drawback is that once the minor reaches the age of majority (age 18 in most states), assets in UTMA accounts become fully accessible to them. These funds could then be used for a flashy new car or a lavish vacation around the world, instead of a higher education as had been intended.
4) Roth IRA’s – Roth IRA’s are well known as a tax-free retirement savings vehicle, but many are less aware of their college planning benefits. Amounts up to what one has contributed to a Roth IRA can be withdrawn from a Roth IRA for qualified expenses. Any earnings, on the other hand, will incur taxes if withdrawn prior to age 59.5 or 5 years after starting a Roth IRA, whichever is later. In addition, Roth IRA’s are not counted towards financial aid and grant eligibility as are other forms of college savings. Like Coverdell accounts, a larger universe of investment options is available within Roth IRA’s. The downside is that direct contributions to Roth IRA’s for higher earners (families with taxable income above $183,000) may not be allowed, although we have found ways around this for some families. Contributions are capped at $5,500 per year with an additional $1,000 catch up for those over age 50. As a rule of thumb, I would suggest maximizing Roth IRA contributions first before considering other savings options. Junior could always receive scholarships and not need the money or self-fund his education, but the majority of us will want to retire someday, making retirement savings much more of a necessity.
5) Taxable Investment Accounts – These offer the most flexibility as there are no contribution limits or investment restrictions and funds can be used for any purpose. The primary focus with this approach should be minimizing taxation for the account holder (usually the parent or relative of the future student). Concentrating on tax-advantaged investments like tax-free municipal bonds and funds, exchange traded funds or lower turnover mutual funds, and non-dividend paying stocks often makes the most sense in attaining a satisfactory after-tax return with this strategy. Generally speaking, this is often the best way to save for K-12 expenses given the limitations of Coverdell ESA’s.
While our politicians could eliminate or change the benefits associated with various college planning strategies, it is best to familiarize yourself with and utilize one or more in the event this occurs. Working with a financial professional knowledgeable in this area can help you balance this and your other priorities to find the right approach for your needs.