It’s almost October 1st. Parents with college-bound students know that October 1st is the earliest they can file their Free Application for Federal Student Aid (FAFSA).
They also know that saving for education is best started early.
Even if done with a standard savings account, getting started early, and maintaining a consistent deposit, will help to lessen the risk to savings later in life. In addition to a standard savings, there are a few other commonly used tools to save for education. Some of the options are briefly described below.
529 Plans
The most commonly discussed education savings tool, is the “qualified tuition plan”, sometimes referred to as a QTP, authorized by U.S. Federal Internal Revenue Code Section 529. This allows individual states to create and maintain tax-free savings accounts for education-related expenses. These accounts are funded with after-tax money, but the investment growth is tax-free when the disbursements are used to pay for “qualified” expenses such as tuition, fees, room and board, and books. These plans are no longer only applicable for college-related expenses. In 2017, the SECURE act expanded the definition of “qualified expenses” to include a yearly total of $10,000 towards those related to K-12 tuition, apprenticeships, and student loan payment per beneficiary. It also created the ability to roll-over 529 account funds into an Achieving a Better Life Experience (ABLE) account to help those under 26 years of age with disabilities set aside up to $15,000 a year in tax-free savings accounts without affecting their eligibility for government benefits like Medicaid and Supplemental Security Income (SSI).
Other positive aspects for using a 529 plan may include; the ability to open an account immediately because there generally is no (or a low) minimum contribution, a high contribution limit, the ability to roll assets into another 529 plan for a different beneficiary, the ability to use any states plan, and some states allow contributions to the plan to be tax deductible. Note too, that account owners can name anyone as the beneficiary. Relatives can create accounts and get the benefits of tax-free growth and disbursements as well. But be aware that disbursements for non-dependent students, unlike those from their parents, will be counted directly as income for that student, and subsequently assessed at 50% for financial aid awards. Meaning an $8,000 disbursement from a grandparent may trigger a $4,000 reduction in the student’s financial aid package. A way to minimize this impact is to waiting until January 1st of the 2nd college year so that it will not make it into the FAFSA calculation. Of course, this only works if the student will graduate in 4 years. There are a couple of other possible ways in which a grandparent may maximize their 529 account’s ability to help the student, depending on the plan guidelines. One may be to transfer ownership of the plan to the student or their parent. Another, is to consider paying up to $10,000 a year on a student loan after graduation.
Not all 529 plans are created equally. Each state’s plan has its nuances. And things can change at any time. Some quick online research, or consulting with a tax or financial professional, will help narrow down the choices to best fit the individual need.
Roth IRAs
Like 529 plans, Roth IRAs offer tax-free investment growth on after-tax contributions. Likewise, early withdrawals are allowed for qualified education expenses after funds have been in an IRA for at least 5 years. Unlike the 529 plans, however, the investor can choose to use the investments for education or keep them in the account for retirement. On the downside, Roth IRA’s have a comparatively low contribution limit. Furthermore, investments in any IRA will count towards the total amount of yearly allowable IRA investment. Using IRA funds should be done judiciously. And only when there is a minimal impact on retirement goals.
Custodial Accounts
The Uniform Gift to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) established custodial accounts as a way for adults to gift assets to children without having to go through the trouble of creating a trust. A custodial account created under the Uniform Gift to Minors Act (UGMA) is used for financial savings much like a bank, mutual fund, or other savings account. Funds placed in these accounts must be used ‘for the benefit of the child’, but control remains with the parent. As the name implies however, these accounts are for minors. Therefore, when the minor reaches the age of majority in their state, they gain full control of the account. Although these accounts do not provide the tax benefits of a 529 plan, the account holder has much greater flexibility in the investment options, and the investment growth is taxed at the child’s tax rate. Furthermore, the funds can be withdrawn without consequence as long as they’re used ‘for the benefit of the child’ and not necessarily for college expenses. For FAFSA reporting purposes, custodial accounts are assessed as the student’s assets and up to 20% of their balance is counted in calculating the Expected Family Contribution.
Prepaid Tuition Plans
Some states allow prospective students to prepay their tuition at certain state colleges or universities, thereby locking-in the cost. Obviously, this is only best when the student is sure of the college they will attend.
Coverdell Plans
Coverdell Education Savings Accounts are similar to 529 plans in that they are tax-deferred savings accounts from which qualified distributions can be taken tax-free. Coverdell plans typically offer a wider variety of savings vehicles than a 529 plan, which usually offer only a limited choice of mutual funds. However, the annual contributions are limited to $2,000 per year, per beneficiary and can only be made by households whose adjusted gross income does not exceed certain amounts; currently (2020) $110,000 for single filers and $220,000 for married couples filing jointly. Other limitations include the fact that the contributions can’t be claimed for deduction or credit and the savings must be used by the time the beneficiary turns 30.
Which Plan Should I Use?
These are just a few of the ways to mitigate the tremendous risk which education expenses can create to retirement savings. A successful ‘best strategy’ may be comprised of many of these options. Composing such a strategy will take time and thought, and is a process best started long before entering high school. This isn’t an easy endeavor, but there are many dedicated professionals which can help. A good place to start is the school counselor’s office. They can provide a thorough overview of the entire financial aid process and help set expectations. A college’s or apprenticing institution’s financial aid office can provide more specific information for their offerings. Seriously consider consulting with tax and financial professionals to craft a long-range savings plan.
For more information regarding choosing an education that best fits the students overall needs, see my series of articles at https://www.stepsfortoday.com/financial/having-the-other-talk-with-your-teen/.
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And remember to take the next step…
Mitch