Ballooning College Costs
The average cost of tuition and fees for the 2016-2017 school year is $33,480 at private colleges, and $9,650 for state residents at public colleges. It averages $24,930 for out-of-state residents attending public universities, according to data provided by the College Board.
Of course that doesn't include an array of other expenses that push costs higher. The average cost of books can add another $1,200 per year, and room and board can run just over $10,000 (College Board). And we haven't even discussed the meal plan will run!
"If you look at the long-term trend, (college tuition) has been rising almost six percent above the rate of inflation," said Ray Franke, a professor of education at the University of Massachusetts, Boston. "That's brought immense pressure from the media and general public, asking whether college is still worth it" (CNBC). Many experts still believe a college degree is the ticket to boosting long-term income. While the soaring costs can be discouraging, savings plans have blossomed, enabling disciplined savers to sock away cash for their kids to go off to college.
So let's look at some of the more well-known savings plans that are available.
Before I get started, let me say that my goal isn't to cover the various plans in painstaking detail, but to touch on these plans in a high-level way. There is a lot of information to learn about these plans so as I always say, my door is open. My team and I are just a phone call or email away. If you have questions about how to save for college or you want to be sure you are on track, let's talk.
That said, let’s jump in and start with the custodial account, more formally known as the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA).
Anyone can make a deposit into a custodial account, but it is managed by an adult, usually a parent or guardian. Any deposits are irrevocable gifts to the child and must be used for his or her benefit.
Generally speaking, the first $1,050 in earnings is considered tax-free and the next $1,050 is taxed at the child’s rate. Unearned income over $2,100 is taxed at the child’s parents’ tax rate. The kiddie tax rule now applies to children under age 19 and full-time college students under the age of 24 (Forbes, T. Rowe Price).
Please be aware, however, that various states require the funds to be turned over to the child when he or she reaches the age of majority, usually 18 to 21. However, there is no guarantee the child will want to spend any “windfall” on college. The siren song of Europe or a new car might be more attractive.
Also, for the purposes of financial aid, custodial accounts are considered assets of the student and could impact financial aid eligibility.
Coverdell Education Savings Account
Next, let’s look at the Coverdell Education Savings Account (ESA—IRS Pub 970). It’s available to you if your modified adjusted gross income is less than $110,000 ($220,000 if filing a joint return).
These plans offer tax-free investment growth and tax-free withdrawals when the funds are spent on qualified education expenses. In addition to college expenses, certain K-12 purchases are also considered qualified when using a Coverdell ESA. Contributions, however, are limited to $2,000 annually.
529 college savings plans
This brings us to 529 college savings plans, a plan the Washington Post called the best way to save for college. But one many don’t use.
The plan allows for various investments in stocks and bonds and is usually operated by the state or a college. As with a Roth IRA account, earnings are not subject to federal taxes when withdrawn, though you must use the cash for “qualified education” expenses, such as tuition, room and board, or books.
Contributions cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary (IRS 529 Q&A), which puts the limit at a much higher level than an ESA. Anyone can contribute not just the beneficiary’s parents. But anything in excess of $14,000 will be subject to the gift tax. Moreover, 34 states and the District of Columbia give the account owner a full or partial state income tax deduction for their contributions to the state’s 529 plan (FinAid.org).
While a 529 can impact financial aid, it is not as onerous as funds in a custodial account. But be careful when it comes to fees.
Maybe it’s the confusing nature of the 529 that causes folks to bypass this savings vehicle. If that’s the case for you, I can’t stress this enough—please feel free to reach out with your questions. That is what I’m here for.
Prepaid tuition plans
Prepaid tuition plans may be an alternative to the 529 plan. These plans, administered by individual states and typically used for in-state school tuition, allow parents to pay for tuition credits in advance at a predetermined price. These plans retain the same tax benefits as 529 plans, but they are not subject to swings in the stock market.
However, if a child goes to an out-of-state school, you may not realize the full value of the plan.
If the family moves out of state but the child attends a participating school, the family can still use the plan but may be held responsible for the difference between out-of-state and in-state tuition, depending on the plan (FinAid.org). Before enrolling in a prepaid plan, it is important to research a plan’s security and whether it’s backed by a guarantee. Also inquire as to what happens if the plan starts to lose money.
Roth IRA account
Lastly, one more plan you might consider is a Roth IRA account. Yes, that’s right—a Roth IRA. Like a 529 plan, the Roth IRA also allows for distributions free of federal income tax if the withdrawal is used to pay qualified higher education expenses, and such withdrawals are exempt from the 10% early distribution penalty (FinAid.org).
Moreover, the Roth in the parent’s name isn’t counted as an asset against the child for financial aid. However, it may reduce or eliminate aid in future years if the distribution is taken in the child’s first year
Remember having your kids graduate from college debt free is possible with some hard work and planning.
As always, when it comes to tax matters, feel free to consult with your tax advisor.