How can you cover your child’s future college costs? Saving early (and often) may be the key for most families. Here are some college savings vehicles to consider.
529 college savings plans. Offered by states and some educational institutions, these plans let you save up to $15,000 per year for your child’s college costs without having to file an I.R.S. gift tax return. A married couple can contribute up to $30,000 per year. You can even frontload a 529 plan with up to $75,000 as an individual and $150,000 as a couple in initial contributions per plan beneficiary – up to five years of gifts in one year – without triggering gift taxes.
529 plans (excluding pre-paid plans) feature diversified investment options that you can select based on the age of your child or simply a static mix of asset classes. You can participate in 529 plans offered by any state, however if you’re looking to deduct contributions (only from your state income), you would use the plan in your home state. Otherwise, you can shop different plans based on their investment options, fees and of course, performance on www.savingforcollege.com.
Regardless of which plan you choose, your child can go to any accredited institution in the country and so long as the account is used for educational expenses, the proceeds are tax-free on a federal and state level. Other advantages are that the account can be transferred to another beneficiary, say a sibling or even to yourself if you have a degree you wish to pursue and a child who wound up not needing the money for education.
It’s also a good idea for grandparents to start a 529 plan. When the grandparents own the account, then it does not need to be reported as an asset on the financial aid forms when your child applies for school, because they only look at assets in the name of the child and the parent. In fact, anyone can set up a 529 plan on behalf of anyone – they need not be related – and a child can be the beneficiary of multiple accounts by different owners.
These plans now have greater flexibility. Thanks to the federal tax reforms passed in 2017, up to $10,000 of 529 plan funds per year may now be used to pay qualified K-12 tuition costs.
Coverdell Educational Savings Accounts. These are the original tax-deferred college savings accounts, however the contribution limit is only $2,000 per year and contributions are not tax-deductible. There are also income thresholds dictating who can contribute to a Coverdell account. Lastly, the funds must be used by the time the beneficiary reaches 30 and if not used for education, then taxes and a penalty will be assessed on the value of the account.
UGMA & UTMA accounts. These all-purpose savings and investment accounts are often used to save for college but can be used for anything, so long as it’s for the benefit of the child or minor. Uniform Gifts to Minors Act or Uniform Transfers to Minors Act is what the acronym stands for so it’s important to understand when you put money in the account, you are making an irrevocable gift to your child. You manage the assets until your child reaches the age of majority (usually 18 or 21 but varies by state). At that point, your child can use the UGMA or UTMA funds to pay for college or anything else for that matter. The account must be transferred to the child at that age. If you have one of these accounts, you can roll them over to 529 plans for tax-deferred growth without the hassle of having to file tax returns for your kids.
Roth IRAs. At first glance, a Roth IRA might seem an unusual college savings vehicle, but a Roth IRA allows you to save for college without the constraints of a college fund. This is an important distinction, because you cannot predict everything about your child’s educational future. If you take funds out of a Coverdell ESA or 529 college savings plan and use them for anything but qualified education expenses, an income tax bill will result, plus a 10% Internal Revenue Service penalty on account earnings.
You gain flexibility when you save for college using a Roth IRA. If your child gets a scholarship, elects not to attend college, or goes to a cheaper college than you anticipated, you still have an invested, tax-advantaged account left to use for your retirement, with the potential to withdraw 100% of it, tax free.
You can withdraw Roth IRA contributions at any time, for any reason, without incurring taxes or penalties. When you are an original owner of a Roth IRA and you are age 59½ or older, you can withdraw your Roth IRA’s earnings, tax free, so long as the IRA has existed for five years. From a college savings standpoint, all this is great: parents 60 and older who have owned a Roth for at least five years may draw it down without any of that money being taxed, and younger parents may withdraw at least part of the money in a Roth IRA, tax free.
You probably know that the I.R.S. discourages withdrawals of Roth IRA earnings before age 59½ with a 10% early withdrawal penalty. This penalty is not assessed, however, if the early withdrawal is used for qualified higher education expenses, even for your child. Earnings are also tax-free so long as you’ve had the Roth IRA for at least 5 years. Unfortunately, there are some income limitations and contribution limits for Roth IRAs.
Whole life insurance. If you have a permanent life insurance policy with cash value, you can take a loan from (or even cash out) the policy to meet college costs. The value of a life insurance policy is not factored into a student’s financial aid calculation. Should you fail to repay the loan balance, the loan will accrue interest and that will lower the policy’s death benefit or possibly lapse the policy.
With all of these options available for college funding, it may be confusing to know where to start. We are happy to discuss your options regarding these savings methods and others.
Kendall Capital is a wealth management firm providing investment management services in the Washington, DC area to individuals and families with assets of more than $500,000.