Back to School: Planning for the Future Cost of College
By Adam E. Day, Financial Advisor
It seems like every year, Labor Day comes and goes and we think, what happened to summer? The kid’s activities pick back up as do practices, clubs and parent teacher conferences. Suddenly, it once again feels like our schedules are running us, versus us running our schedules. For many of our clients that have children that are in high school, college visits, entrance tests and general angst about what to do about post-secondary education begin to fester. Education planning is a topic that is brought up frequently during our autumn financial reviews: “How do we pay for college?”
The cost of the typical 4-year university undergraduate program has increased 747.8% since 1963, even after adjusting for inflation (1). Wages have not kept up with that level of inflation, meaning that paying as you go for education is much more difficult for the average family to achieve. Many explanations are possible on why the costs are so inflated and is subject to much debate on how to fix the systems for the future. However, we as planners and stewards of capital, are here to serve families within the current system. Some estimate that a family with a young child may pay over $35,000 per year for an in-state public program or $82,000 per year for a private program by the year 2037. Getting ahead of this as much as possible will be crucial for families who want to try to rely as little as possible on student loans. There are many different options that we must discern when looking at savings vehicles for education planning.
With both 529 plans and ESAs, earnings may be tax-free as long as withdrawals are used to pay for qualified education expenses.
1. 529 Plans
Most states offer 529 college savings plans. Most are national plans and are available to residents of any state, but not every state’s plans offer in-state residents additional state income-tax benefits. 529 plans are tax-deferred; potential for tax-free qualified education distributions; no income limitations for participation; higher contribution limits than ESAs; and minimal burden of investment decisions. Each state’s 529 plan has a different menu of investment options, similar to a 401K or 403B.
The rules for 529 plan distributions, when not used for qualified expenses, are more stringent than some of the other account types as the earnings part of a non-qualified distribution is taxed at one’s marginal tax-rate plus a 10% penalty unless an exception applies.
Another important feature of the 529 plan is that the beneficiary of the account can be changed. For example, if child number one decides not to go to college, the 529 plan beneficiary can be changed to a sibling. There are some limitations to this feature so this should be discussed with your advisor in further detail before setting up an account.
2. Coverdell ESA
An ESA is a tax-deferred account and has the potential for tax-free qualified distributions for elementary, secondary, and post-secondary education. The maximum annual contribution is up to $2,000 per beneficiary. Eligibility to contribute to an ESA is based on the contributor’s modified adjusted gross income, so not all families are eligible to contribute to this type of account.
Similar to the 529 plans, the rules for distributions, when not used for qualified expenses, are more stringent than some of the other account types as the earnings part of a non-qualified distribution are taxed at one’s marginal tax-rate plus a 10% penalty unless an exception applies.
3. Series EE Bonds
Series EE savings bonds are low-risk savings products that earn interest until they reach 30 years or you cash them, whichever comes first. The only way to buy EE bonds is to buy them in electronic form in TreasuryDirect.gov
1. Custodial Accounts (UTMA or UGMA)
A custodial account is one where a parent or appointed custodian exercises supervisory powers and makes distributions for the benefit of the minor. All gifts/transfers to the account are irrevocable and the assets may be used only for that child's benefit. At the age that custodianship ends, the child assumes control. Thus, the parent or custodian loses all control. This account differs, as it is more flexible than a 529 Plan or ESAs on how the funds can be used.
Taxes levied on a custodial account depend on the child’s age and whether the account’s income was generated through taxable or tax-free investments.
2. Invest in your own name
Some clients choose to open a separate non-retirement account, often joint with the spouse to set aside funds which are earmarked for college education. To maintain maximum control over the assets in their ‘college-savings’ account, they invest in their own name. Under this arrangement, owner invests however they choose and may opt to give the child access to the account’s assets when they decide to do so — if at all. The trade-off is that taxes are due on the account’s earnings at the owner’s marginal income tax rate, but they get to maintain control and don’t have to pay penalties should the child not go to college.
One Additional Strategy
1. Prepaid College Tuition Plans
Some states have active pre-paid tuition plans. As the name implies, it allows families to pre-pay future college costs. Most of these plans have state residency requirements and institution requirements so reading the fine print will be very important to be sure this if this an appropriate option or not.
A Breakdown of Different Ways to Save for College
Flexibility is worth considering
When it comes to college savings, if possible, having a multifaceted approach is a great option. For example, there is risk of having everything planned for college only set aside in a 529 Plan. If the student were to not attend college, the asset would have to be transferred to another beneficiary or taken out with taxes or penalty. Having assets in addition to a 529, like a UTMA account, allows for more flexible distributions for items such as a car, transportation or extracurricular actives fees.
1. Start early. Just like investing for retirement, the best tool one has for college savings is time. It’s the old adage, “time in the market is more important than timing the market.” The same holds true with college savings strategies.
2. Birthday gifts.When sending out birthday invitations for your child’s birthday parties, consider including instructions on how friends and family members can give to the child’s UTMA or 529 plan. Many states now have a birthday card insert, that you can print and include that will direct instructions on how to make a 529 plan gift.
3. Bring this up during your next review. If you have not started your college savings plan or maybe you have not looked at it in a while, looking at both the asset location and asset allocation are important to do as part of your annual review process. You will want to make sure that both the account types and investments align with the timeline and goals for the funds. It is our job as Financial Advisors to cover this topic as part of your annual review and we look forward to helping you along this journey.
Wells Fargo Advisors Financial Network is not a legal or tax advisor. Be sure to consult your own tax advisor and investment professional before taking any action that may involve tax consequences.