If you have children or grandchildren, you probably spend a significant amount of time thinking about their futures. And for many children, college will be an important part of that future.
As you think about ways to help them prepare for that formative part of their lives, you will need to answer some key questions:
• How much does a college education cost? For the 2018-19 academic year, the average annual cost (tuition, fees, and room and board) was $21,370 for in-state students at public four-year colleges or universities; for four-year private schools, the corresponding expense was $48,510, according to the College Board (*i). You can expect these costs to continue to rise over the next several years. Over the previous decade, average total college costs for in-state public schools increased at an annual rate of 2.6% above inflation, according to the CollegeBoard (*ii).
• Is it worth it? Most data suggest that college is a good investment. Over an adult’s working life, the average difference between a high school graduate’s and a college graduate’s wages is about $1 million (*iii). In addition to the financial benefits, many people believe that there are social and psychological benefits of higher education as well as benefits of having a transition period between living at home and entering the workforce.
• How can you help? There are many ways that you can help fund a loved one’s college education. But one thing is certain: The more help you can provide, the better your loved one’s chances of avoiding overwhelming student debt. Upon graduation, the average borrower has almost $30,000 in loans (*iv) —and many students are graduating with six-figure debts. This type of debt load can be a long-term drag on borrowers, harming their ability to get a mortgage, locking them into jobs they may dislike and weighing down their retirement savings.
For many parents and grandparents, helping their children and grandchildren minimize their student debt is a top financial priority—and there are many ways to do that. We examine 529 college savings plans and other methods for funding a loved one’s college dreams.
529 College Savings Plans
The most popular college-savings vehicle is a 529 plan—and for good reason. These plans offers several benefits:
• Tax–free growth – With a 529 plan, your earnings accumulate tax free, provided they are used for qualified higher education expenses, such as tuition, fees, and room and board.
• Tax deductions – Several states offer income tax deductions for contributions made to that state’s 529 plan. For example, if you are an Illinois resident and you invest in one of the state’s 529 plans, such as the Bright Directions College Savings Program, you can deduct up to $10,000 (as an individual) or $20,000 (as part of a married couple) from your taxes (*v).
• Flexibility – Investing in a 529 plan gives you flexibility in two different ways. First, you are free to invest in the plan offered by any state, even if you don’t live there. (However, if you invest in a plan outside your state, you won’t be able to claim your home state’s tax deductions or other incentives.) The second type of flexibility is your ability to switch beneficiaries. For example, if you name one child or grandchild as a beneficiary of a 529 plan, and that child doesn’t end up going to college or other post-secondary training or receives a substantial scholarship, you can switch the beneficiary to another loved one—it isn’t limited to just a child or grandchild. And due to recent tax law changes, 529 plans can now also be used to pay for qualified expenses at secondary and elementary schools.
• High contribution limits – The lifetime contribution limits for 529 plans are quite generous; while these limits vary by state, each state’s plan allows for maximum contributions of at least $200,000 per beneficiary.
• Avoidance of gift taxes – You can contribute up to $15,000 per year, per beneficiary, without incurring the federal gift tax. Furthermore, 529 plans allow you to contribute up to $75,000 for each beneficiary in a single year without federal gift tax consequences, as long as you don’t make other gifts to the same beneficiary in the same year or in any of the next four calendar years.
These benefits can make a 529 plan an attractive choice for you as you seek ways to help pay for your loved ones’ postsecondary education—whether that means college or some type of trade school. Yet, 529 plans, like all investments, come with elements which you should be aware of before you invest.
• Taxes and penalties for non-qualified expenses – 529 plan distributions not used for qualified expenses may be subject to federal and state income tax and a 10% penalty on the earnings. Consequently, you will want to be reasonably assured that you will have at least one beneficiary who will actually use the money in the plan for education. Also, you will want to avoid “over-funding” your 529 plan and possibly leaving yourself open to the taxes and penalties on unused funds. But even this “worst-case” scenario might not be that bad—after all, if the money isn’t used for education, you can tap into it for your own purposes, such as paying for retirement. You will be taxed on the withdrawals (and, as mentioned, will likely face a 10% penalty), but you probably would have been taxed on this money anyway, if you had never placed it in a 529 plan. Still, a 529 plan is designed to build resources for education, so try to use it for this purpose.
• Impact on financial aid – 529 plans can affect the beneficiary’s financial aid package. Most colleges base their aid calculations on the Free Application for Federal Student Aid (FAFSA), which currently counts up to 5.64% of “unprotected” parental assets in determining federal or state aid—and a 529 plan would be one of those assets. If you are a grandparent, the value of your 529 plan will be excluded from FAFSA, but the withdrawals themselves will be counted as untaxed income to the student. This money could certainly affect aid decisions. So, you may want to contact a financial aid professional to discuss the potential effects of any gifts you are considering.
Other College Funding Methods
While a 529 plan is a popular choice for college savings, it is not the only option available. Other vehicles you might consider include:
• Coverdell Education Savings Account – A Coverdell account is similar to a 529 plan in that earnings and withdrawals are tax-free, provided the money is used for qualified education expenses. But while anyone can invest in a 529 plan, regardless of income, a Coverdell account has income restrictions—and, perhaps more importantly, the maximum contribution amount is just $2,000 per year. Plus, a Coverdell ESA operates more like a custodial account, in which the funds are the property of the beneficiary and cannot be revoked. By contrast, a 529 plan owner—not the beneficiary—retains control of the assets over the life of the account. Still, a Coverdell account offers more flexibility in investment choices than a 529 plan.
• UGMA/UTMA account – You could give your children or grandchildren financial assets, such as shares of stock, through a custodial account, usually known as a Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) account. However, you only control a custodial account until your children or grandchildren reach the age of majority, at which time they take it over. At that point, they can use the money for whatever they want—and their plans may not have anything to do with books or classes.
• Paying directly for tuition – Even if you have already used all of the $15,000 annual gift exclusion for a child or grandchild, you can still contribute financially to their education that year. Payments made directly to the educational institution to pay for tuition aren’t subject to gift tax. This exclusion, however, doesn’t apply to books, room and board, or other non-tuition expenses.
Don’t Jeopardize Your Retirement
It is natural for many parents and grandparents to put their loved ones’ needs first and contribute as much as they can to a 529 plan or other college-savings vehicle. This caring attitude is certainly admirable, but you shouldn’t let your generosity jeopardize your own financial goals—in particular, a comfortable retirement.
Your children or grandchildren have other resources to help pay for college, such as scholarships, grants and campus employment. Even if they do have to take out some loans, your children or grandchildren will have many years in which to repay them. In addition, students may even be able to greatly bring down their total price tag by completing some of their credits at an affordable community college.
Like most things in life, deciding between saving for retirement and saving for college expenses is a matter of understanding all of the trade-offs and prioritizing.
At The Retirement Network, we are here to help you think through all of these questions and find the right balance between helping your loved ones get a good start in life—while helping you enjoy the retirement lifestyle you have envisioned.
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.
i. CollegeBoard, “Average Published Undergraduate Charges by Sector and by Carnegie Classification, 2018-19” (https://trends.collegeboard.org/college-pricing/figures-tables/average-published-undergraduate-charges-sector-2018-19)
ii. CollegeBoard, “Average Rates of Growth of Published Charges by Decade.” (https://trends.collegeboard.org/college-pricing/figures-tables/average-rates-growth-published-charges-decade)
iii. Georgetown University, “The Economic Value of College Majors.” (https://1gyhoq479ufd3yna29x7ubjn-wpengine.netdna-ssl.com/wp-content/uploads/The-Economic-Value-of-College-Majors-Full-Report-web-FINAL.pdf)
iv. CollegeBoard, “Average Cumulative Debt Levels in 2017 Dollars: Bachelor’s Degree Recipients at Four-Year Institutions, 2001-02 to 2016-17.” (https://trends.collegeboard.org/student-aid/figures-tables/cumulative-debt-bachelor-degree-recipients-four-year-institutions-over-time)
v. Bright Directions, “Bright Directions FAQs” (https://www.brightdirections.com/faqs)