This article explores the importance of having an education savings plan, the main vehicles for saving including their advantages and disadvantages, and often-overlooked pitfalls to consider when saving for education.
School is officially out, which for most kids marks their “true” start to summer. This was my favorite time of year when tests and homework were replaced with summer camp and weekend trips to the Jersey Shore.
What it also marked was being one year older, which in turn meant one year closer to attending college. As the years passed by, unbeknownst to me, the stress and anxiety of “how am I going to afford college” only grew for my mom.
Her stress, I am confident, is shared with most parents as they try to navigate saving for their children amidst the exorbitant rise in college tuition costs. The numbers are staggering – since 1980, college tuition and fees in the US have increased by 1,200% while the Consumer Price Index (CPI) has only increased by 232% over the same time period.
I believe Benjamin Franklin said it best: “Failing to prepare is preparing to fail,” which is why we partner with our clients in developing an education savings plan as part of their overall financial plan. In this article, I will explore some of the vehicles that parents can use to save for their kid’s future education expenses, how best to approach an education savings plan, and some of the often overlooked pitfalls of saving for your children’s education.
Types of Education Savings Plans
While there are many ways for a parent to save for college, two of the most common methods are saving into a 529 Plan or UTMA/UGMA.
Section 529 Plans
529 Plans come in two types: Savings Plans and Prepaid Tuition Plans. We will focus on Savings Plans, as Prepaid Tuition Plans are more limited in their uses and availability.
A 529 Plan is a college savings plan that offers tax benefits and is named after Section 529 of the Internal Revenue Code (IRC). Each 529 plan is sponsored at the state level, so while all plans follow the same rules and regulations, the underlying investment choices, fees, and state tax benefits will differ from plan to plan.
Nearly every state now has a 529 plan, but you don’t have to use your resident state’s 529 Plan or attend college in the state that sponsors your 529 Plan. In fact, 529 Plans can now be used at over 6,000 US colleges and universities and over 400 foreign colleges and universities regardless of the state that sponsors the plan.
A 529 Plan works a lot like a Roth savings account in that contributions to the account are made with after-tax dollars. Those funds then grow tax-free, and distributions from the account are not taxed if used for qualified education expenses. Further, over 30 states offer a state income tax deduction or credit for 529 contributions – subject to residency and account ownership. Contributions are not deductible at the Federal level.
Taking Money out of the Plan
While funds from a 529 Plan can be withdrawn for any reason, if they are not used for qualified education expenses, the earnings portion of the plan will be subject to ordinary income tax and a 10% penalty.
Qualified education expenses include tuition, fees, books, supplies, computers and potentially room and board. Recent tax law changes have also expanded the use of 529 Plan funds. The Tax Cuts and Jobs Act in 2017 expanded qualified distributions to include $10,000 per year, per beneficiary, for K-12 tuition expenses; the SECURE Act of 2019 now allows qualified distributions for student loan repayment of up to $10,000.
On its face, overfunding a 529 Plan may be problematic since funds not used fully for qualified costs may be subject to taxes and penalties. However, there are several workarounds, including changing the beneficiary of the account to qualifying family members for their education costs, or holding the funds in the account for graduate school. Further, the 10% penalty is waived if your child receives a tax-free scholarship, so the earnings would only be subject to ordinary income tax.
Limits on Contributions
Contributions to 529 Plans are considered a gift for tax purposes. This means that each individual is allowed to contribute up to the annual exclusion limit ($15,000 per beneficiary in 2021) to each beneficiary’s 529 Plan without counting against their lifetime estate and gift tax exclusion. Remember that the annual exclusion limit also includes non-529 gifts, so be sure to consider any outside gifts when making a 529 contribution.
One of the unique advantages to 529 Plans is the ability to “front-load” or “super fund” the account. It is the only vehicle for which the IRS allows individuals to use 5 years’ worth of annual exclusion gifts in one year, which means that a married couple can potentially contribute up to $150,000 in a single year and spread the gifts from a gift tax perspective over 5 years.
While there are no annual maximum contribution limits, all 529 Plans do have a lifetime maximum contribution limit and those range from $235,000 to $529,000 depending on the state who sponsors the plan. This limit only applies to contributions, not investment earnings.
As an alternative, or in conjunction with 529 plans, parents may choose to save for college using custodial accounts allowed under state legislation: the Uniform Transfers to Minors Act (UTMA) and the Uniform Gift to Minors Act (UGMA) accounts.
An UTMA/UGMA is a custodial bank or brokerage account that is technically owned by a minor child, but since a minor child cannot own assets, the account is managed by a custodian (most often a parent) until the child reaches the age of majority. The age of majority is either 18, 19, or 21 depending on the state. There are several advantages and disadvantages of saving for college using an UTMA/UGMA versus a 529 Plan.
- Convenience: An UTMA/UGMA account can be opened with nearly any bank, credit union, or investment custodian.
- Investment Options: While 529 Plans are very limited in their investment choices, UTMA/UGMA accounts can be invested in nearly anything a regular bank or brokerage firm can invest in (for example, individual stocks, ETFs, mutual funds, and CDs).
- Uses: The money in an UTMA/UGMA can be used for many things beyond just qualified education expenses unlike a 529 Plan.
- Contribution Limits: While contributions to an UTMA/UGMA are considered a gift for gift tax purposes like 529 Plans, unlike 529 Plans, there is no contribution limit for a UTMA/UGMA.
- Tax Benefits: While 529 Plans offer similar tax benefits to a Roth account and may provide a state tax deduction or credit, an UTMA/UGMA does not. Also, UTMA/UGMA accounts are income taxable and fall under the IRS ‘Kiddie Tax’ rules which means the account can create a tax liability for parents.
- Control: A 529 Plan always stays within control of the parent. With an UTMA/UGMA however, once the child reaches the age of majority in their state, the account is fully under his/her control, meaning that an 18–21 year-old may have access to a substantial amount of money at a very young age.
- Irrevocability: Gifts to an UTMA/UGMA are considered irrevocable gifts to that beneficiary and cannot be taken back and the beneficiary cannot be changed in the future. Once the gift is made, those assets become that of the child forever.
- Financial Aid: 529 Plans have financial aid advantages that UTMA/UGMA do not. More detail on this below.
What is the best college savings approach for me?
Now that you know your various options to save for college, what is the best approach? How much should you save? And should you save monthly, annually, or on a lump-sum basis?
Whenever we begin the discussion of college education planning with clients, we often use the analogy of “putting your oxygen mask on first, before helping others” as you often hear when you’re on an airplane. In the same respect, the priority should always be saving and investing for your future-self before saving for you children. Remember, your children can always borrow for college, but you can’t borrow for retirement.
If you have excess cash flow to save beyond what is needed for your future self, then developing a college savings plan could make sense.
If you have the ability, it’s always a good idea to start saving more sooner. This allows the funds to grow and compound for a longer period of time.
As far as funding, we can make certain assumptions to calculate the future cost of college. For example, if you have a young child who will be attending college in 15 years with a current cost of $55,000 year, using the 10-year historical average inflation rate for college costs of 5%, the total cost would be about $493,000 over 4 years. Assuming you currently have zero saved for college, and target a portfolio to earn 8% annualized over the 15 years, you would need to save about $1,513 month, or $18,150 a year, or make 1 lump sum deposit of $155,359.
Of course, there are factors that will be impossible to predict when your child is only 3 years old – the cost of college in today’s dollars, whether he or she will be eligible for scholarships, or whether he or she will even go to college. With that in mind, we often recommend clients either save less (for example target saving ~70-80% of the estimated total future cost) or, if using a 529, have a plan for any excess funds in the account, such as moving it to another beneficiary, or using it for graduate school.
Another important point, as is evident in my example above, if you have the ability, it’s always a good idea to start saving more sooner. This allows the funds to grow and compound for a longer period of time.
When choosing an investment allocation, we often recommend an age-based portfolio. Like a target date fund often seen in retirement plan, an age-based portfolio rebalances automatically over time to become more conservative as the expense of college draws near.
Depending on your goals and wishes for your child’s higher education, a 529 Plan or an UTMA/UGMA can be great options. As far as which type of account is best, if you are looking for flexibility in use and more investment options – perhaps the UTMA/UMGA. If you are looking for tax savings and lesser inclusion for financial aid purposes, perhaps the 529 plan is best.
Pitfalls of College Savings Plans
There are some often overlooked pitfalls associated with both options that deal with financial aid.
First, let me provide a little background on how financial aid works. When applying for financial aid using the Free Application for Federal Student Aid (FAFSA), it is expected that parents and students can contribute a percentage of their assets and income towards the cost of college. This is known as the expected family contribution or EFC. The higher the EFC, the less financial aid a student is eligible for.
Assets and income from the student will be counted at a much higher percentage than those of the parents. So, if receiving financial aid is a goal, then it’s important to keep income and assets lower for the student versus the parents. This is where the type of account you save into, and who owns the account become important.
- 529 Plans that are owned by the parent with a child as the beneficiary (most common scenario), are considered assets of the parent, which is more favorable from a financial aid perspective.
- UTMA/UGMA accounts are considered an asset of the student, and any unearned income (dividends, interest, or capital gains) are reported as income for the student which, as mentioned above, count more heavily towards the EFC calculation.
- 529 Plans that are owned by the grandparent may seem like a great option since they are neither owned by the parent nor student. However, withdrawals are treated as student income for financial aid purposes.
With regards to grandparent owned 529 Plans, there are two ways to avoid its negative effects on financial aid. Because income is counted at a much higher rate than assets in the EFC calculation, one strategy is to change ownership of the account to the parent of the student prior to college. Another strategy is to wait to use the 529 Plan assets until the student starts their junior year of college. This is because the FAFSA is computed using income and assets from 2 years prior, meaning that the student will be out of college before the 529 Plan withdrawals will count as the student’s income.
There are many ways that parents can save for their children’s future college education costs, and each has its advantages and disadvantages. Regardless of the vehicle used, developing a plan early on – as most things related to financing planning – is important. Whether it’s saving for retirement or education, “failing to prepare is preparing to fail”.
That being said, before making any decision on savings for education, please consult your SAM advisory team to help align your education savings plan with your overall financial goals. It’s important to take a holistic approach to determine the best strategy for you and your family and we are here to help.
At SAM our dedicated team of professionals consider it our fiduciary duty to provide clients with the highest standard of care and service in the advisory world. To learn more about how we may help you, get in touch with a SAM advisor today.