Guide to Funding College Education
By Kiel VanderVeen
The first step is to decide which avenue to pursue: do you want the student to come out debt free or do you want the student to have some "skin in the game"? If students know they are responsible for a portion, or all of the student loan repayment, they often take college more seriously. Once you know how much the student will be responsible for through student loans, simply take the total cost of education you are targeting minus the student loan portion, and the amount you will cover from free cash flow each year. This number will give you a rough idea how much you will need. You may want to run an inflation calculation or speak to an advisor to assist with those calculations.
Now that you have a target dollar amount to save, the next thing to consider is what vehicle to use for college savings. We will look at four account types commonly used:
• 529 plans
• Coverdell Educational Savings Accounts
• US Savings Bonds
• Custodial Accounts
529 accounts are the most tax advantaged way to save in Nebraska and Iowa. Contributions are made to the plans with a maximum of $70,000 in one year (uses 5 years of gifting at the $14,000 per year gift tax threshold), and a state tax deduction of up to $10,000 in Nebraska and $3168 in Iowa. The contributions are invested in various portfolio options offered by each state. Any earning on the accounts are tax free if used for qualified education expenses. However, if the earnings portion is not used for education, there is a 10% penalty in addition to income tax.
Coverdell ESAs are similar to 529s, with lower contribution limits, but can be used for K-12 education. Additionally, Coverdell accounts must be used by the time the beneficiary reaches 30.
For both 529s and Coverdell ESAs, the funds can be transferred to another beneficiary if it is not needed or used for the first beneficiary, which allows for the owner to control use of the funds.
US Savings Bonds are one of the more flexible options best used for lower income savers. The bonds' proceeds may be excluded from federal and state income tax if used for higher education and income limits are met.
Lastly, custodial accounts, often referred to as UTMA/UGMA accounts, are the most flexible in terms of what the dollars are used for. Custodial account contributions are gifts to the minor that become available for the minor at an "age of majority", which is different in each state. The earnings are subject to income tax and may cause "Kiddie Tax" rules to apply. Additionally, for student aid purposes these accounts are considered the student's assets and the person contributing has no control over the how the assets are used.
What to do if college is next year and you haven't saved at all? First, don't panic! 529 accounts can still be used as a "checking account" for education expenses, allowing for a state tax deduction (limits apply) in Nebraska and Iowa. Additionally, it is important to pay for at least $4500 of qualified education expenses out of pocket or from student loans in order to utilize the American Opportunity tax credit available for the first four years of college.
Finally, a common mistake is to use all liquid assets in the first few years, ignoring loans. This can cause a cash crunch later on when available loans may not be enough. Loans are offered each year, but have limits for the yearly amount borrowed. Typically, lower income borrowers will qualify for subsidized loans that accrue interest after graduation. Higher income borrowers qualify for unsubsidized loans subject to interest payments immediately. Because the loans offered may not be enough to cover the cost of education (tuition plus room and board), it is important to borrow wisely in the early years. So consider accepting subsidized loans early to ease cash flow later.
If in a real crunch for education dollars, Roth and Traditional IRAs can be tapped without penalty. Roth IRAs can be used tax and penalty free for higher education expenses, with limitations. However, this may impact retirement funding. Traditional IRAs may be used for high education without penalty, but are still subject to income tax and potentially impact retirement funding. Some 401ks offer loan provisions. Normally, I do not recommend 401k loans due to decreased contributions, lower rates of return, and lack of tax deductions for interest. If there is nowhere else to turn, a home equity loan may offer a lower rate and better deduction options than a 401k.
Regardless of how to fund a college education, it is a good investment in the future of a young person. Proper planning about who will take the financial responsibility and how to do so can alleviate some of the stress. As always, your education funding plan should be reviewed with an advisor or CPA.
This information does not purport to be a complete description of the securities, markets, or developments referred to in this material, it is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Opinions expressed are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also a risk that these plans may lose money or not perform well enough to cover college costs as anticipated. Most states offer their own 529 programs, which may provide advantages and benefits exclusively for their residents. The tax implications can vary significantly from state to state. Please note that changes in tax laws may occur at any time which could have an impact on your situation. While I am familiar with the tax provisions of the issues presented herein, as a Financial Advisor of RJFS, I am not qualified to render advice on tax matters. You should discuss tax matters with the appropriate tax professional.