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Presented by Amy Fink, Financial Advisor
Many parents and children find it challenging to pay 100% of the costs for college education, but with good planning, you can significantly defray those costs.
The cost of college education grows ever higher, each year. In fact, a recent CNBC report suggests that today's babies will find that their college degree could cost as much as a half-million dollars by the age of 181! That's a frightening number, especially when you consider that 70% of today's graduates already carry education debts past graduation2.
Step One: Start now
The important thing is to get started as soon as possible—even if you do so with modest, periodic deposits into a college savings plan. Let friends and relatives know that contributions would be welcome birthday gifts. While grants and scholarships are ideal, there's no guarantee your child will receive one.
Step Two: Ask questions
Today, there are a myriad of good choices: 529 plans, Coverdell Education Savings Accounts, custodial accounts created under the Unified Gifts to Minors Act (UGMA), Unified Transfers to Minors Act (UTMA). But which ones are right for you? There may be more than one answer.
To begin, answer a few basic questions:
- What types of tax benefits are most important to you? (deductibility, deferral, tax-free withdrawals, etc.)
- Do you wish to have flexibility to change beneficiaries? (if your child gets a full-ride scholarship, would you like to be able to change the beneficiary to another family member?)
- Would you like more flexibility in investment choices?
- Would you prefer inflation-adjusted plans?
- How much do you plan to contribute, annually? (different plans have different annual contribution limits.)
- Do you wish to also cover costs of private primary or secondary tuition?
- What percentage of your child's total education expenses do you plan to cover? Do you expect your child to pay for some of all of his/her college costs?
Step Three: Examine the most common choices:
- Section 529 college savings plans feature generous lifetime contribution limits and no income restrictions that govern eligibility to contribute.
- Coverdell Education Savings Accounts allow withdrawals to pay elementary and high school expenses in addition to college costs, but annual contributions are capped at $2,000 per beneficiary and income limits apply.
- UGMA/UTMA custodial accounts are not college savings accounts, per se, but do offer gift tax and estate tax benefits to contributors; however, when the minor reaches adulthood, he or she assumes complete control of the UGMA/UTMA assets and is not required to spend the money on college.
- State-sponsored prepaid tuition plans allow parents to pay today's tuition rates with the assurance that the child will have the money to go to college when the time comes. They also allow participants to defer paying federal income tax on earnings.
There are significant differences between the account types, including the definition of qualified expenses, contribution limits, income limits, ownership of the account, and other restrictions. Keep these in mind as we take a look at each option.
529 College Savings Plans3
Named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states or, in some cases, by qualified educational institutions. They are administered by investment companies, which also oversee the underlying assets. There are two types of 529 plans:
The College Savings Plan
This one is most familiar to the average saver/investor. It allows for contributions into portfolios of mutual funds or similar investments. Most are national plans –so residents of one state may use a plan sponsored by another state.
Key features of 529 college savings plans:
- Earnings accumulate free from taxes.
- Contributions are placed in investments like mutual funds, which may offer the potential for higher gains, but also with added risk.
- Qualified withdrawals are federally tax free and may be exempt from state taxes (tax rules vary state to state).
- Generous lifetime contribution limits that often exceed $200,000 per beneficiary.
- Tax rules that let anyone give up to $15,000 in 2017, free from federal gift taxes, to as many individuals as they choose. Donors also have the option of averaging a single lump-sum contribution over five years, effectively allowing them to give up to $75,000 at one time, gift-tax free.
- No income restrictions on contributors to a 529 plan.
- Money in a college savings plan may be used at any eligible college or university for qualified expenses such as tuition, books, and computer equipment. However, withdrawals not used for defined education purposes may be subject to income taxes and a 10% additional federal tax.
- The Individual who creates a 529 plan account on behalf of a beneficiary generally maintains complete control over the account.
- Account owners may change beneficiaries (should one child not go to school, you can change the plan to another child).
- Contributions are not deductible for federal income tax purposes , but may provide a state-tax deduction for residents of the sponsoring state. If your state or your designated beneficiary's state offers a 529 plan, you may want to consider what, if any, potential state income tax or other benefits it offers before investing.
- New in 2018: You can now withdraw up to $10,000 per year from your 529 for qualified K-12 private school tuition/fees4.
- Also, it is important to compare plans as fees vary for these types of plans. Some are more expensive than others.
The Prepaid Tuition Plan
Less well known is the 529 prepaid tuition plan, which lets you pay future tuition at today's rates, essentially taking inflation out of the equation. These types of plans tend to be available for state residents only, while the units may be used at any university that participates in federal financial aid programs.
These plans allow parents (and relatives) to "buy" tuition for the child at a fixed price. You either pay in full or pay installments. The state guarantees that your investment will keep pace with rising college costs. Depending upon the number of years you have until your child first enters college, your costs may vary.
- Plans allow you to lock in tomorrow's college costs today.
- Assets held in prepaid tuition plans are not counted against the beneficiary (student), which results in a lower impact on need-based financial aid5.
- Some state plans offer additional tax advantages. Check with each plan for more information.
- Since these plans are designed to help protect against future inflation, investment rates of return may not be as robust as returns you might receive in other investments, such as stocks and mutual funds. On the flip side, they offer more protection against a market crash or unexpectedly high increases in tuition costs. With these plans, you're buying future educational credits at today's prices.
- Plans may have limited flexibility. If your child chooses to go to an out-of-state or private college, he or she may receive only some of the benefits. If you want to transfer the amount to a sibling, some plans may disallow it. If your child decides not to go to college at all, or you choose to withdraw money for some other expenditure, you may face strict refund policies.
- Many plans impose a heavy penalty for withdrawing money for any reason other than college tuition, and may charge an additional 10% federal income tax on top of the penalty.
Coverdell: New Name, Additional Benefits
Coverdell Education Savings Accounts, known previously as Education IRAs, allow tax-free withdrawals for elementary and high school expenses in addition to college costs.
Key features include:
- Contributions are capped at $2,000 annually per beneficiary and are made with post-tax money. Excess contributions are subject to a 6% federal excise tax.
- Contributions are not deductible from income for federal tax purposes.
- Coverdell account earnings and growth is tax protected.
- The deadline to contribute to a Coverdell is generally April 15, the same deadline that applies to IRAs.
- Account owners may change beneficiaries.
- You cannot contribute if your modified adjusted gross income is more than $110,000 if you file singly, or more than $220,000 if you file jointly.
- Qualified withdrawals may be used to pay for an elementary, secondary, or college education.
- The beneficiary can take withdrawals at any time, but any amounts in excess of his or her qualified education expenses will be taxable as jointly.
- Assets must be used before the beneficiary's thirtieth birthday.
UGMA/UTMA custodial accounts are not technically college savings accounts, but do offer gift-tax and estate-tax benefits to contributors. Under the guidelines of UGMA or UTMA (nomenclature varies by state), adults may establish and contribute to a custodial account in a minor's name without having to create a trust or name a legal guardian.
Other key features:
- No limits on contributions.
- No withdrawal restrictions as long as the money is used for the benefit of the minor.
- The minor is the beneficial owner, not the contributor, but the contributor controls the account until the child is of age.
- Investment earnings are not taxable for the contributor, because the account is owned by the minor, but the minor may be subject to taxation at the kiddie tax rate, which became potentially more onerous in 2018 following passage of the Tax Cuts and Jobs Act.
- Upon reaching adulthood, the child gains complete control of the account and is not required to spend the money on college.
As previously mentioned, choosing a college investment option is not necessarily a "one or the other" decision – it may make sense for you to contribute to more than one type of account simultaneously. A financial advisor and your tax advisor can help guide you based on your particular needs.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. BECU Investment Services and LPL Financial do not provide tax advice or services. Please consult your tax advisor regarding your specific situation.
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
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5Need-based college aid is awarded based on your family's financial need. All federal aid is need-based. Your need is determined by subtracting your expected family contribution (EFC) from the coast of attendance (COA) at each college/university.
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