Updated: September 1, 2015
Wait! Before you move on to your next e-mail, thinking “my kids are through college,” consider for just a moment – you may wish to contribute toward the education of a niece, nephew or grandchild.
College savings accounts have two fundamental objectives – savings discipline and tax reduction. Even if you don’t need the discipline, increasing lifetime spending power by paying less in lifetime taxes is always a good idea.1
Types of accounts – pros & cons
We’ll compare the most popular types of college savings plans, including 529 plans, the new and improved Coverdell Educational Savings Account (ESA), Series I bonds, Uniform Gifts to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) accounts, and plain old savings accounts. We’ll also consider retirement savings accounts as vehicles for college savings. Each has its own charms, but for most people, there is a clear winner.
In evaluating the accounts, you’ll want to consider several issues:
- How attractive are after-tax investment returns? Do you have access to a full range of investment options, or are there some restrictions? Are there tax advantages, or not?
- How big a balance can you build? That is, can you save the full balance you need in one kind of account, or will you have to establish multiple kinds of accounts to do so?
- Are the funds transferable? Can you use them at any college? If not, and you choose a college that won’t accept them, what happens then?
- What else can be done with the money? What happens if you save more than your child needs for college? Or what if your child chooses an inexpensive school after you’ve saved enough for an expensive one, or earns a full scholarship? Or, your child may decide not to go to college at all. What can you do with the money in the event that a portion or all of the money is unused?
- Whose money is it? This influences whether the money will be used as you intend or not. Your child might use their money to buy a Lamborghini instead of a college education. You won’t spend your money that way (unless you suffer a particularly acute mid-life crisis).
- How do savings dollars count toward assessing financial aid? Accounts that parents own (or that colleges treat that way for the purposes of assessing financial aid) have another advantage – colleges expect you to contribute a less from them than from accounts your children own toward college costs. Some colleges don’t expect you to contribute from retirement assets at all – a major advantage for IRAs and 401(k)s.
529 Savings Plans – Most states offer these accounts. They offer a small number of investment alternatives, many of which reduce risk and return as your child’s college enrollment approaches. Families in one state are free to choose a plan offered by another state. Contributions are sometimes tax deductible for in-state residents (unfortunately, this is not true in Massachusetts). Assets accumulate tax-free, and investment returns you spend for qualified expenses (post-secondary education) are tax-free. These plans are very similar to Roth IRAs, but contribution limits are much higher, at 401(k) levels.
Even if this tax break expires in 2010 as current law envisions, the returns are still taxable at your child’s rate – lower than yours, quite likely. The only potential drawback – a 10% tax penalty on earnings you don’t use for post-secondary education, in addition to the taxes you pay on those earnings at ordinary income rates. Scholarship recipients avoid the tax penalty, but still must pay taxes on the earnings.
Each state has made a deal with one or more investment managers to manage the portfolios. Choose carefully – investment management expenses vary widely.
529 Prepaid Plans – Most states offer these advance purchase plans for participating colleges.
In Massachusetts, 80 colleges agree to accept your account2 as follows:
- If your deposit in the plan this year equals 100% of this year’s tuition at a participating college, that institution will give you credit for 100% of tuition whenever your child matriculates. If your deposit equals 50% of this year’s tuition, they give credit for 50%, and so on. A deposit can be used at any of the 80 colleges when your child is ready.
- If your child picks one of these schools, you can be assured of keeping pace with the rapidly rising price of college.
- However, if your child doesn’t choose one of those 80 schools, your account may be worth a good deal less than if you had invested in the 529 Savings Plan – earning only bond returns, or perhaps even less.
Coverdell Educational Savings Accounts – are available through brokers and mutual fund companies, and do not vary by state. You could think of these as the Roth IRA of education (in fact, the former name is “education IRA”). They have relatively low contribution limits ($2,000 per year) but investment returns are tax-free if used for a qualified purpose. And these plans are more flexible than 529 plans – secondary education is also a qualified use. These plans also have a 10% penalty on earnings not used for educational purposes. [Unfortunately, these plans are fully available only to families with incomes less than $190,000 per year, and are not available at all to families with incomes over $220,000.]
Series I Bonds – tax advantaged Federal government bonds. These bonds are protected against inflation, and may have a role in your portfolio even if not for financing education. Earnings are state and local income tax free, and federal income tax deferred. For qualified taxpayers (income less than $114,000), earnings are fully or partially excludable from federal income tax, if used for qualified higher education expenses (tuition and fees). Up to $30,000 per year can be invested. Many families will find this sufficient to finance the full amount of college costs.
UGMA and UTMA (officially, Uniform Gift to Minors Act and Uniform Transfer to Minors Act, but pronounced as they look – Ugh-ma and Uht-ma) – the old standbys. These accounts have no tax advantages related to education. They do allow the transfer of assets to your children, and children’s incomes (up to $700 and $1400) probably are taxed at lower rates than yours.
Simple savings accounts, either in a bank or in a mutual fund or brokerage account – these accounts can provide savings discipline, but they offer no tax advantages.
The dark horses – qualified retirement plans (401(k)s, deductible IRAs, Roth IRAs, 401(k)s, etc.) – All of these plans offer tax deferral. Importantly, many colleges do not count these assets in calculating the expected family contribution (EFC). However, you may incur tax penalties for by withdrawing from your IRA to pay for college before age 59½. That reduces your after-tax rate of return significantly. Similarly, pre-retirement withdrawals from 401(k)s to finance college education are subject to significant restrictions:
- Pre-retirement withdrawals are treated as loans, which must be repaid;
- only tuition and fees (not room and board) can be financed without tax penalties; and
- “only” $50,000 can be withdrawn, limiting the size of the contemporary contribution to education expenses.
As a result, IRAs and 401(k)s are attractive college savings choices for parents who
- do not intend to use the full amount of capacity in these plans to save for their own retirement; and
- will reach age 59½ by the time they need to withdraw the funds for college; or
- don’t mind borrowing the money for college finance until they do reach 59½3.
If your retirement savings capacity is “used up,” you must use other accounts for college finance. The table below summarizes:
Among non-retirement accounts, 529 plans are best if you can be sure you will spend the accumulated assets entirely on post-secondary education. The only drawback is the tax penalty on excess funds. A Coverdell plan offers similar after-tax return potential, and offers the flexibility of including secondary education as a qualified use. It shares the tax penalty on excess funds. The additional limitation? The restriction on annual contributions may limit your accumulation, especially if you are late in starting to save. However, nothing stops you from having both – the Coverdell offers the flexibility of allowing you to save for secondary school costs, if that is something you are considering.
If you would like more information on college savings options, please see the table detailing the features of each option on our Web site at www.sensiblefinancial.com or give us a call at 617-444-8677. We’re more than happy to answer your questions or set up a meeting to review your financial situation.