Springtime always brings about a change in the greeting card aisle. There are suddenly caps and gowns adorning the cards with the year splashed across for good measure. The selection often includes money-holders. For most graduates, however, the funds they find in those cards come graduation day will fall woefully short to fund a higher education. You have heard it before but it bears repeating: take appropriate steps early and start saving if pursuing further education in the future.
There are a multitude of ways to fund an education. Before we get into that, however, let’s look at some investing basics.
First, match your risk tolerance with your goal timeline. For example, an investor that is 30 years old with a kindergartner can be more aggressive and take more risk in their retirement account than in their college account. The reason is simple – this hypothetical investor won’t need retirement funds for 35 years, they will need college funds in 12. Take less risk in a portfolio if the timeline is short.
Next, think about what the best type of program is for putting money away. Here are some common solutions:
The 529 plan
Becoming increasingly well-known and run by states, this can be an incredibly attractive way to save for college. These plans allow the account owner (often a parent) to contribute after-tax dollars to an investment vehicle. The owner names a beneficiary. So long as the beneficiary uses the funds for qualified educational expenses, the earnings and withdrawals are tax-free. If the beneficiary doesn’t use the funds, they can be transferred to another beneficiary. However, withdrawn funds not used for qualified expenses subjects the account owner to a 10% penalty as well as income tax. Some states even allow for 529 contributions to reduce state tax owed.
What distributions qualify for favorable tax treatment? Quite a broad array. Room and board, tuition, books and computers all qualify in certain circumstances.
The Private College 529 Plan
This is a bit confusing, as the Private College 529 plan differs quite significantly from a traditional 529. A group of private colleges administers the plan. It functions more like a prepaid tuition system than a traditional 529. The basic idea is that you purchase tuition credits at today’s tuition rates. You then used the credits in the future at one of the participating schools. So, if the school in question costs $20,000 today and you buy $10,000 (50% of tuition) and when your child goes to school tuition costs $50,000, you have enough credits to cover $25,000 – 50% of the cost.
This particular plan has a narrower view of “qualified distributions”. For example, you cannot use your prepaid tuition credit for room and board. You also must hold the credits for 36 months prior to redeeming. If the student decides not to enroll in a participating school, you have the option to transfer the credits to a traditional 529. However, keep in mind that with this plan the most you can recognize from gains or losses is 2%. This means that the student could miss out on maximum gains if the plan rolls over from the private college 529 to a traditional one.
Some people choose to use both a state-run 529 with the Private College 529.
UTMA and UGMA Accounts
Uniform Transfer to Minor Act (UTMA) and Uniform Gifts to Minor Act (UGMA) accounts are accounts that are set up by a parent on behalf of a minor. They are custodial accounts. They can hold a wide array of investments. You can use the funds in the accounts for anything that is of benefit to the minor. These accounts offer flexibility in what they will cover when it comes to school costs. The custodian can take distributions to pay for anything that is a benefit for the student; making it much more all-encompassing. The minor receives full ownership of the account when they reach the age of majority as defined within the account documents.
The funds placed into an UTMA or UGMA account are considered to be irrevocable. This means that the person putting the funds in cannot take the funds back; they are the property of the minor. The income on these accounts is also taxable; whether to file on the parent’s taxes or have the student separately file is a discussion with a tax preparer.
White Oaks Wealth Advisors’ CPA Laura Bereiter states, “Contributions to an UTMA/UGMA are limited to $15,000 per donor (ex. each parent) in 2019. Upon transferring the funds, the parent loses the ability to change their mind, and the child will have full access to the account balance when he or she reaches the age of majority (usually 18 or 21, depending on the state). Both the parent and child will be affected from an income tax perspective via the complex rules of ‘kiddie tax’ imposed on the income earned by the investments in the UTMA/UGMA. Parents may find more tax advantages by contributing the $15,000 to a 529 plan, where the investment income is tax-deferred and the funds remain an asset of the parents.”
Using retirement accounts to fund an education
While we are big proponents of keeping retirement accounts for retirement, not education, some people do lean into their IRAs in order to fund educations. For purposes of education, IRAs will forego the 10% early withdrawal penalty (401Ks do not have this same provision). Withdrawals do still carry taxes due, so the withdrawal amount needed increases to cover taxes.
One of the biggest considerations is that the FAFSA treats withdrawals as income, not as a parental asset. Higher income has a bigger impact on the overall amount of federal aid a student is eligible for, if any. A different tack with the retirement route is to use 401k loan proceeds for education. The benefit here is that you are taking a loan against an undisclosed asset on the FAFSA and any interest you are paying on the loan is back to yourself. If the account owner severs the employment relationship, the whole of the outstanding balance is due immediately. This is a real risk. Again, we believe that retirement assets are for retirement.
Cash flow
Another option is to cash flow the expenses, if you are able. This seems like it would make sense, but weigh the pros and cons. If using cash is going to make it harder to invest in your retirement, think twice. It is important to keep invested and to be a regular, disciplined investor. Especially when it comes to your retirement.
FAFSA considerations
Lastly, think about what each type of account will do for your student’s Free Application for Federal Student Aid (FAFSA). Fill out the FAFSA to understand how much, if any, aid your student is eligible for. A 529 or Private College 529 will reflect as a parental asset. The first $20,000 or so of parental assets are exempt from inclusion in the expected family contribution. Above the exemption amount, the expected family contribution includes a maximum of 5.64% of assets. The FAFSA does not consider withdrawals from 529s as income.
UTMA and UGMA accounts are considered to be the student’s. The FAFSA includes these accounts toward the expected family contribution. Student-owned accounts have a larger contribution expectation in the calculation. As such, the amount counted toward the expected contribution is 20% of the assets. Additionally, capital gains, interest, and dividends are income on the student’s tax returns. The FAFSA counts these items at 50%.
The FAFSA does not include retirement accounts of any kind. Therefore, these accounts do not count toward the expected family contribution. The higher the expected family contribution, the lower the amount of financial aid your student may be eligible for.
Remember, when it comes to funding an education, start saving early and save often. If you need help determining a strategy for your student’s education, reach out to your advisor.