by: Amanda Vaught
As financial advisors we spend a lot of time talking about retirement planning, but we can also help you navigate a college savings plan that’s best for your family’s situation. Those who make a plan save, on average, twice as much as those who don’t.
First, I want to stress that your priority should always be your own retirement savings. There are no loans available for retirement like there are for college. Being a financial burden on your future children is not a legacy you want to leave.
College Savings Accounts: You have many choices beyond a 529
With that caveat out of the way, let’s review the different types of accounts you could use to save for your child’s education. There are several different types of accounts you could use for your child’s education savings – which one (or combination) is best for you depends on your individual preferences and circumstances.
529 plans allow contributions to grow tax-free for the beneficiary’s ultimate use as education expenses. Each state in the US administers its own 529 plan, and the rules and investment choices available vary greatly. You usually don’t have to live in a state to use its 529 plan, so it could pay to shop around for a state plan that suits your needs best. You can also open a 529 plan through most brokerage firms.
Contribution limits vary by state. For example, New York has no annual contribution limit for their 529 plan. As of 2021, each beneficiary has an aggregate limit of $520,000. Contributions to a child’s 529 count towards your annual gift tax exclusion, currently at $15,000 per year per person ($30,000 per year for a married couple). If you contribute over the annual amount, you must file a form 709 with the IRS on your tax return, but no extra tax is due unless you gift more than $11.7 million (per person) in your lifetime. Most people fall far short of this limit.1 (Note annual gift tax exclusions and 5-year gift-tax averaging would apply to any contribution to a beneficiary.)
Depending on your state, the contributions may also be tax-deductible. For example, in 2021 New York residents can deduct up to $5000 of contributions from their state tax return, if filing as an individual, and $10,000 if married filing jointly, if they use the New York’s 529 College Savings Program. (Please note that tax rules are subject to change.)
Funds can be withdrawn tax-free to pay for most college costs and expenses. In 2020, the Federal law changed allowing 529 funds to be used for all types of education expenses, not just college. As of this writing, eleven states have not adopted this law, and withdrawals for K-12 expenses are not qualified for tax-free withdrawals. The new law also allows account owners to use 529 funds to pay up to $10,000 of their own student loans.
Different states offer different investing options. Not all 529 plans are created equal, so you should explore your options as you are not restricted to using the plan in your state. Unfortunately, most 529 plans have very limited investment options, but many states are expanding their offerings. For example, 17 different plans currently offer at least one ESG investing option.2
Coverdell Education Savings Account (ESA)
ESA accounts, formerly known as Education IRAs, are another type of tax-advantaged account for education savings. Funds can be used for a wide variety of education expenses, including primary school.
The maximum contribution is $2000 per year per child, but they are not tax-deductible. Contributions are also subject to an income limit. For 2021, income limits are capped out at $110,000 (single/head of household) or $220,000 (married filing jointly).
All funds must be disbursed or rolled over to another related beneficiary by the age of 30, unless the beneficiary has special needs.
A key advantage of ESA plans is the ability to invest in a wider array of assets than with 529s. You can open an ESA plan through a brokerage firm, such as Charles Schwab.
UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) accounts are another vehicle for saving for your children’s education. Unlike 529s or ESAs, there are no limitations on how your child can spend funds from this account. For parents unsure whether their child will attend college, this flexibility may make more sense. Once the child reaches the age of majority, (age 18 or 21 depending on your state of residence), the account becomes the child’s to spend the funds as they choose.
UGMA and UTMA accounts have no limits on contributions, but be aware of potential tax implications. Funds in a UTMA/UGMA do not grow tax-free as they do in 529s or ESAs. For example, a potential tax issue to consider is that any earnings on the investments over $1100 and up to $2200 per year (2021) will be taxed to the child and require a tax return. Anything over $2200 earned per year is taxed as Kiddie Tax.3
If you plan to apply for financial aid, be aware that UGMA/UTMA assets count as student assets on the FAFSA and can add significantly to the expected family contribution (EFC). In contrast, 529 assets, if owned by the parents, are reported as a parent’s assets
Once your child is in high school, for instance, and you have a better idea of whether or not they will go to college, you can convert assets from the UGMA/UTMA to a 529. The conversion allows you to avoid an increased EFC. Contributions to a 529 must be in cash, so you have to sell any assets from the UGMA/UTMA to move them to a 529, which could result in capital gains taxes. Be sure to consult with a tax professional if you are considering this route.
For an “older” parent, Roth IRA accounts offer tax-advantaged growth of assets. If a parent turns age 59 1/2 while their child is in college, the parent can withdraw the funds tax-free, and without penalties, to help with college (and don’t forget graduate school!) expenses.
Roth contributions are limited to $6,000/year (or $7,000 if you’re over age 50) and are subject to income limitations. For 2021, the income limit is between $125,000 and $140,000 (single) and between $198,000 and $208,000 (married filing jointly). If you fall between the range, you are allowed a prorated contribution.
In general, we recommend that most Roth funds should be reserved for the parent’s own retirement nest egg. Depending on the parent’s (or grandparent’s) financial situation, however, using a Roth for college expenses could be a good option.
Brokerage Savings Account
Not sure what to do or what your child will do? A brokerage account is a great catch-all for general savings for long-term expenses.
There are no IRS contribution limits and can be invested any way you like. Funds can be withdrawn when needed for your child’s college, your own retirement, or other expenses as you see fit.
Brokerage accounts are the most flexible of the options presented and can be a great benefit if well-managed and planned.
How much to save?
How much you need to save depends on the current age of your child and your preferred amount of assistance. A first step is to look at the potential cost of college for your child. In the below chart (be forewarned – some refer to this as a “heart attack” chart), JP Morgan estimates the cost of a four-year college education by age.
Source: JP Morgan Asset Management, using The College Board, Trends in College Pricing and Student Aid 2000. Future college costs estimated to inflate 5% per year. Average tuition, fees and room and board for public college reflect four-year, in-state charges.
Yes, that says if you have a newborn now, your child’s estimated college expenses for four years will be $526,629 for private schools and $230,069 for public ones.
Note that these tuition numbers are averages. If you or your child wants to attend an elite private school, the cost would be significantly higher.
The cost of a college education can be more than your house. And if you have more than one kid, it can be up there with the amount you need to save for your own retirement. Large numbers like these can be overwhelming. The best route forward is to break it down – how do you get where you want to go?
Impact of Savings on Financial Aid
Most families won’t be able to save the amounts necessary to pay for a child’s four-year college education, and they expect to rely on financial aid.
Graphic via JP Morgan Asset Management
Many families expect financial aid to cover a large percentage of their child’s education. The reality can be much different than perception. The amount of scholarship and grant money available has been decreasing over the years. If the average cost of education is $80,000 per year, financial aid and scholarships currently cover less than 10% of the cost.
How to Get There
If financial aid won’t be especially helpful, how can you help your child pay for college? The key aspect of saving for college is taking advantage of compounding. Cash alone will not get you there.
For example, if you save $1250 each month ($15,000 per year) for 18 years your cumulative savings would be $270,000. In contrast, if you deposited this sum each month into a 529 account and invested it with an annual return of 6%, your account could be worth $486,612. (See the below chart.)
By investing instead of leaving your savings in cash, you get a whole $216,612 MORE. You are actually close to the $526,000 estimated cost of a private 4-year college education if your child is currently a newborn. If these funds are in a 529 account, then you can withdraw them tax-free to pay for their college expenses.
Chart assumes a $1250 deposit per month earning 6% per year, compounded monthly. Past performance is no indication of future returns. The 6% return is calculated as net of any fees.
Planning is Power
No matter your level of disposable income, people who plan for their child(ren)’s college savings save, on average, twice as much as those who don’t. Planners are twice as likely to start saving for college by age 6, and their children have 47% less expected student loan debt. (Source: Sallie Mae, Higher Ambitions, How America Plans for Post-secondary Education, 2020). Let us help you plan today.
1 This is not tax advice. Numbers are tax rules are subject to change at any time. Be sure to consult your tax professional regarding your specific situation.
2 Including environmental, social and governance (“ESG”) criteria in your investment decisions is a way for you to put your money where your values are. Inclusion of ESG factors is generally compelling from both a cost and performance standpoint. For more background on ESG, see my recent blog article, “Social Values Investing: A Propel Primer”.
3 You can learn more about the kiddie tax in this article: "Understanding the Kiddie Tax".