How To Save For a College Education

How To Save For a College Education

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You are probably expecting your children to go to college one day, and they probably should because college offers many benefits to those who attend and graduate.  College graduates earn more and spend less time unemployed than their counterparts without a college degree.  There are other lifelong benefits too, such as a network of friends and an appreciation of learning.

How much does college cost?  I think most people would say it is a lot, despite all of the benefits mentioned above.  Four years at a public college with in-state tuition could be as low as $60,000 in total, but private colleges could easily exceed $250,000.  And costs have been rising significantly faster than inflation.

Since college is going to be so expensive, you should start saving early.  But what is the best way to save?

529 Plans

The most well-known and widely used savings vehicle for college expenses is the 529 plan.  These are state-sponsored plans that allow investment gains to be tax-free if withdrawals are used for qualified college expenses.  The contribution limits are high and some states offer a tax deduction for contributions, up to an annual limit.  No state imposes a contribution limit based on income, and the owner retains control of the account, including investments and distributions.  In addition, because the account belongs to the owner and not the student beneficiary, the existence of the account has a limited effect on financial aid.

However, you are limited to investing in the available funds offered by the state and in order to get a state income tax deduction for contributions, most states require that the money be invested in their plan.  So if you are a NY state taxpayer and would like the deduction (for state purposes, none is available for federal purposes) you must contribute to one of two NY state plans.

Custodial Accounts

Custodial accounts, or UGMA and UTMA accounts are another way to accumulate money in a tax-advantaged way.  The first $1,100 of earnings realized in any year is not taxed, and the next $1,100 is taxed at 10% federal.  And you can invest in virtually anything, so if you want to buy only Amazon stock, you can do it with a custodial account.

However, the money belongs to the child and must be used for their benefit.  Once they reach age 18, or 21 in some states, they can spend the money on whatever they want, not what the parent wants.  Also, because the money is the child’s, a custodial account will more significantly reduce financial aid than a 529 plan.

Coverdell Accounts

The Coverdell account is very similar to a 529, except that no state tax deduction is offered, the maximum contribution is $2,000 per year, and income must be below certain thresholds in order to be eligible to contribute.  The only advantage of a Coverdell relative to a 529 plan is the ability to use funds for any level of education.

IRA

You can withdraw money from your IRA and generally avoid the 10% early distributions penalty regardless of age.  However, you will pay tax on the withdrawals from a traditional IRA and tax on the withdrawals from a Roth IRA if they are made before you are 59.5 or the account was opened less than five years.

IRAs were created as a vehicle for retirement savings, so using funds for college may leave the owner with a deficiency in retirement income.  But if you find yourself in a situation where you cannot save in both an IRA and a 529, choose the IRA because of the added flexibility in the use of assets.

If the child has earned income, he/she can open an IRA regardless of age, but a Roth IRA will probably make more sense because a child’s income tax rate is likely to be low, minimizing the value of the tax-deduction of a Traditional IRA.

Taxable Accounts

If you are not using one of the vehicles above, you are using a taxable account.  Tax-advantages are limited and not geared towards education (i.e., municipal bond interest and lower capital gains rates), but the accounts are the most flexible in terms of possible investments and liquidity.

Borrowing for College and Other Financial Aid

The Free Application for Federal Student Aid, or FAFSA, is used to determine Expected Family Contribution, or EFC.  Colleges determine how much federal aid you’re eligible to receive using the EFC.  The calculation is fairly complex, but 50% of a student’s income above $6,400 is expected to be used towards his/her education, as is 20% of his/her assets.  For parents, the figure ranges from 22-47% of income and 5.64% of assets.

Since savings count far less than income for parents, parents should not forgo savings with the idea that it will be made up by the federal government.  If grandparents have saved money in a 529 for the grandchildren, they should not withdraw the funds to pay for college expenses until the Junior or Senior year of the student.  The reason for this is twofold:

  1. Withdrawals from a grandparent’s 529 is considered income of the student, reducing the eligibility for financial aid, but
  1. There is two year lag between income and asset reporting on the FAFSA form and the year in which aid is given.  If withdrawals don’t occur until the junior year, then the student’s high income for FAFSA purposes isn’t relevant since they have already graduated (hopefully).

Summary

Being able to save significant amounts towards your child’s college education is truly a luxury, because you should be saving towards your own retirement and other family expenses, such as a home, first, and those other savings goals could easily take up 15% or more of your income.   If you are not likely to receive any financial aid, then you will either have to decide how much you will spend from your assets and how much your children can afford to borrow or spend of their own money.

Securities offered through Kestra Investment Services, LLC.,(Kestra IS) member FINRA/SIPC.  Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS.  J Matrik Wealth Management is not affiliated with Kestra IS, Kestra AS, or Five Star Professional.

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