Choosing the Right College Savings Plan

Date31 May 2018

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When it comes to saving for your children’s college education, there’s a wide variety of investment vehicles, each with pros and cons, to select from. Wealth Advisor Sue Stevens looks at what some of the popular options have to offer.

The advantages of a college education are numerous: potentially higher income levels over a lifetime, learning about subjects that can help in finding a job or meeting people that may help you throughout your life. But the costs can be intimidating. The most important step is just starting to save something. Once you’ve crossed that hurdle, you need to figure out where to put your savings. There are lots of college investment vehicles, so let’s take a closer look at what some of the most popular offer.

529 College Savings Plans

Perhaps the most commonly used type of college savings vehicle is the 529 College Savings Plan. These plans are typically sponsored by individual states or financial institutions. No matter which plan you invest in, your child can use that money to attend college anywhere in the country. You gift money to these plans and as long as your child uses the money for “qualified education purposes,” the earnings are tax-free. See the chart at the end of this article for what qualifies as an expense.

You can gift up to $15,000 (2018) per person each year. This is known as the “annual exclusion” amount for gift tax purposes. There is a special exception for 529 plans that allows you to contribute up to five times the annual exclusion, or up to $75,000 (2018) per child, in any one year. Just keep in mind that you’ve then used up the annual exclusion for that five year period.

If your child doesn’t use all the money in his or her 529 plan, you can transfer it to another “qualified beneficiary’s” plan. Qualified beneficiaries would include siblings, parents (or ancestors of either), nieces or nephews, aunts or uncles, first cousins, sons-in-law, daughters-in- law, fathers-in-law, mothers-in-law, brothers-in-law, sisters-in-law and spouses of any relatives previously listed.

Note: The ability to use 529 Savings Plan money for another beneficiary is a unique feature that is not available when you use college savings vehicles like UGMA/UTMA accounts. Those accounts are strictly for the named beneficiary.

Parents (or owners) maintain control of the assets in a 529 plan until distributed and the assets are factored into the financial aid formulas at a more advantageous rate.

There are, however, some disadvantages to 529 college savings plans:

You are limited to changing investments twice a year.
Although the number and quality of investment choices within 529 plans has improved, you are limited to the options offered by your chosen plan.
Pay attention to the costs of the Sometimes costs can be higher than you would find in alternative types of investments.
Any assets not used for qualified education expenses will subject the earnings in the plan to income tax and a 10% You can avoid this by “rolling over” the plan to another qualified beneficiary.
In some cases, especially with high net worth families, the annual gift tax exclusion may be better used in another way. For example, tuition can be paid directly to the school and not count toward the gift tax. If a Family Trust has been established, you may want to use your annual gift tax exclusion to fund the Family Trust.

But if the advantages outweigh the disadvantages for you, how do you choose among all the possible 529 College Savings plans available? The most important factors to consider are:

State Tax Advantages:
Many states offer tax deductions for residents investing in their state’s 529 plan. Some states also offer generous matches for first time enrollment in their plans. This may serve as an attractive incentive, but you can’t ignore other factors, such as fees and investment choices, especially when the tax advantage is relatively small.

Note: Since the Tax Cuts and Jobs Act of 2017, states are now scrambling to rewrite their own rules about what qualifies for a tax deduction. Withdrawing money for private K-12 qualified expenses may have unintended consequences like being required to repay prior state deductions or pay tax on investment gains. Every state is different, so you’ll need to do a little research to learn more. (Read http://time.com/money/5093099/529-plans-k12-expenses-tax-bill/.)

Investment Choice:
Having the “right” investment alternatives in the plan is critical. Especially in volatile markets, you need to have investment options that give you confidence. Many plans have added fixed income choices that should help do just that.

Fees and Expenses:
Not only do you pay a fee to the managers of the 529 plan, but you also pay a fee for the individual mutual funds the plan invests in. Both of these costs need to be accounted for when comparing the total expenses of various 529 plans. You do not want to make the mistake of choosing a plan with a low management fee, only to find out the individual funds in it have very high expense ratios or vice-versa.

The Tax Cuts and Jobs Act of 2017 expands how you can use 529 College Savings Plans assets. Now you can also take up to $10,000 a year to apply to private K-12 qualified education expenses. But this brings with it some additional considerations:

How will that affect the state tax deduction you took when you made the contribution? Will you have to pay part of that back?
Should you invest the money for K-12 differently because you have less time for the money to compound?
If you take out money for K-12, will you derail the growth you were planning on to pay for college expenses?
Will having the money available for K-12 change the financial aid calculations for what parents have to contribute for private school?

Alternative College Savings Vehicles

Not everyone will choose to use a 529 College Savings Plan, so let’s take a look at other savings alternatives:

UGMA/UTMA (Uniform Gifts to Minors Act/Uniform Transfers to Minors Act):
A UGMA/UTMA account is probably the most common type of investment account for a child other than a 529 plan. The appeal is that you can invest in anything–stocks, bonds, CDs, mutual funds–at just about any brokerage or bank. The money has to be used for the benefit of the child and can’t be used for normal parental obligations. At age 18 or 21, depending on state law, the money belongs to the child and can be used for any purpose. This type of account is a disadvantage for financial aid as it is counted as the child’s asset and is subject to a higher percentage in the financial aid formula.

Note: Investment income earned above $2,100 is subject to “kiddie tax” rules. With the new tax law, instead of being subject to parents’ rates, this income is now subject to potentially higher trust rates.

Coverdell Education Savings Account (ESA):
Coverdell accounts allow you to contribute $2,000 a year from all sources that can be used for elementary and secondary school expenses as well as qualified college costs. To be eligible to contribute, your income can’t be over $110,000 (single) or $220,000 (married filing joint). Beneficiaries must be under age 18 when the account is established. Any income earned on these assets is not taxed federally. They offer the ability to invest in just about anything–like a UGMA/UTMA. They are counted as a parent’s asset in the financial aid formula.

Traditional Brokerage Account:
Some parents choose to forgo the tax advantages of other types of college savings accounts so that they maintain control of the assets. For example, some parents will fund a 529 plan to cover the cost of four years of public college. To the extent the child wants to go to a more expensive school, parents pay that portion of the cost out of savings in their own names.

U.S. Savings Bonds:
There are limited advantages for college savings with U.S. Savings Bonds. To get the tax savings in 2017, your income must be less than $93,150 (single) or $147,250 (married filing joint), you must be over age 24 and the money must be used for tuition and fees. There is a $10,000 maximum annual purchase for electronic I-Bonds and EE-Bonds ($15,000 if you purchase a $5,000 paper I-Bond with your tax refund).

IRA:
Typically an IRA holds assets earmarked for retirement. But some people choose to use the money for college costs. You can avoid the 10% penalty if you use the money for college costs from a traditional IRA. You can withdraw contributions from a Roth IRA (but not earnings) without penalty. Overall, we would tend to recommend using these plans for retirement and not for college funding.

529 Prepaid Tuition Plan:
529 Savings Plans (as described previously) are not the only kind of 529 plan. There are also Prepaid Tuition Plans, although these plans have had a number of problems. Prepaid tuition plans were designed to lock in the future cost of tuition, but as state governments have hit their own financial difficulties, these plans may not be able to deliver on those promises. In general, we would not recommend investing in this type of plan.

2503c and Crummy Trusts:
High net worth investors may have additional factors to consider when thinking about funding college for their children. There are a couple types of trusts, 2503c and Crummy, where money can be put aside for future uses including college. One of the more important considerations in these situations is where the annual gift tax exclusion amount can best be used. There are legal costs associated with setting up these trusts, so they are not for everyone.

Once you’ve decided to start putting aside money for your children’s education and formulated a strategy to do so, choose the college savings tool that makes the most sense for your family and your unique financial circumstances. The costs associated with a college (or a private K-12) education can add up quickly, so be sure that the investment vehicle you select is the right one for you.

Download this table as a PDF »

Disclosures
The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

529 College Savings Plans

Alternative College Savings Vehicles

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