College Saving Options
What is the best vehicle to save for college/education?
In order to answer that question, there is another question that needs to be answered first: What will “college or education” look like for your child or grandchild?
For a few people this answer is easy – my grandson wants to be a college professor… my daughter wants to be an attorney… my granddaughter wants to be a ballerina… The education roadmap is fairly straightforward in these instances. However, this isn’t the case for the majority.
Ancient Greek philosopher Heraclitus stated There is nothing permanent except change. Thousands of years later, this still rings true.
What does an education roadmap look like for your child or grandchild when:
- your student states with absolute certainty what they want to do?
- traditional higher education has shifted to a standardized foundational education leaving college graduates without specified training in many instances?
- trade schools and alternative educational routes are becoming sought after?
- and…. who knows what is lies ahead, especially if your “student” is 10-15 years away from needing this education?
With the prospect of change, a key ingredient is essential. Flexibility. So, let’s consider that by looking at some different funding methods and the flexibility of each.
Prepaid Tuition Plans: The foremost benefit of a prepaid tuition plan is the ability to lock in education costs in today’s dollars and protect against the cost of education increasing, which has historically been the case. While this is a huge benefit, it is important to understand the limitations of flexibility within these plans. You can transfer the plan to family members in most cases. You are limited to in-state or even the institution whom you purchased the plan from. This means if your child chooses to go out of state, you would cover the difference between your plan account balance and the actual costs. You are primarily limited to directing payments to tuition and mandatory fees only—no room, board, supplies, etc. And if no one uses it…most plans provide a refund of some sorts, but only for so many years after the beneficiary turns 18. The small print in the plan is extremely important here. Oh… and these plans can reduce financial aid dollar for dollar since they are considered a direct resource.
529 Plans: Firstly, and unlike the impact on financial aid by prepaid tuitions plans, 529 plans held in a grandparent’s name will not have any bearing. You can also design the distributions of these plans to come out in later years of higher education to further benefit your financial aid eligibility if these are parent owned, which means the payouts have to be included in the FAFSA. There are several other benefits to a 529, especially following the expansion measures made in the Secure Act. Here are a few:
- The funds grow tax deferred, but are limited to the investment choices of the specific plan you choose;
- There are state income tax benefits as well within some states, which is also true of prepaid tuition plans. Indiana, for example, offers a 20% credit on up to $5,000 of contributions;
- The benefits – if used for qualifying expenses – are usually tax free. If they are not used for qualifying expenses, there may be a 10% penalty and tax on earnings;
- You can use up to $10,000 per year for K-12 tuition.
- You can use up to $10,000 to pay student loans for the beneficiary or sibling.
- You can roll over up to $35,000 to a Roth IRA (OVER TIME and subject to limitations).
- They can be used for almost any higher education school in any state as well as an increasing number of trade (or similar) schools.
- Room, board, supplies, and more can be paid for in addition to tuition and fees
- You can transfer the beneficiary benefits to a host of family members from a sibling to a _____ in-law to a step-_____.
Roth IRAs and Kiddie Roth IRAs: The contributions to a Roth IRA are limited in comparison to the prior tools. $6,500 is the maximum amount that can be contributed for someone under age 50 this year…and they have to have that amount of “earned income” to be able to contribute. This may not be the sole savings vehicle for reasons stated below, but it shouldn’t be ignored.
A Roth IRA is a retirement tool, but the funds can be used for qualified higher education expenses much like a 529 without penalty. Side note—to not have this penalty, the first contribution to the Roth also needed to be made more than 5 years previous to the distribution. At that point, you take your contributions and conversions come out first, which is tax-free. The earnings come out next and are not penalized, but they are taxable if you are not 59 1/2. There are obviously deductions and tax credits that can potentially help offset these. Not to mention… if your child owns the Kiddie Roth, they may not have any other income. This could mean little to no taxes anyway. However, you may want to look at this as a partial funding strategy and leave the earnings for later. After all, these could be used for up to $10,000 on a first-time home purchase with zero penalty and tax. Or they could be used in the traditional way and provide tax-free income in retirement.
In regard to financial aid, the Roth account balance doesn’t work against you, but the distributions from the Roth IRA could. This means that using the distributions in the later years of higher education could actually be more beneficial.
Life Insurance: This one is probably the most financial aid friendly as it does not have to be included on a FAFSA. It may make sense to explore building cash value in a life insurance policy to later utilize for education. The distributions are first your return or premium, then taken as a loan against your policy. Both of which are not taxable. There are absolutely no limitations to what the money can be used for. It could also guarantee funding an education in the event of death. However, you do pay for the cost of insurance and any interest on loans. Buyer Beware: This is a complex strategy and should not be implemented with just anyone or any insurance company—expertise and quality are key. It also requires ongoing management. For example, if your loan defaults, your entire death benefit amount could be taxable. That door-to-door salesman may not be around when you need this the most.
Okay. This is a lot of information – and we didn’t even cover scholarships, UTMAs, Coverdell accounts, and a few others. The bottom line? “Do not do the job alone!” Saving for higher education is complicated, but can be made simple. Your job isn’t to provide the solution, but just to ask the right questions.
- What is the money for?
- What are the most important issues the money will need to address?
- Where do we need flexibility?
- How much do we want to save?
Start there, then call us.