What you need to know about saving for your children’s College Education
Most of you have flown on commercial flights, so you know that prior to take-off it is the time for the safety announcements. What do they want you to do if there is a loss of cabin pressure and the oxygen masks drop down? Those of you who answered, “Put your own mask on first before putting them on your kids,” are correct. Why should you do this seemingly selfish act? It’s simple: You want to be breathing and conscious so that you can help your kids put their masks on.
The same logic applies to retirement planning and saving for college. You want to make sure that you are saving for your own retirement first before saving for your kids’ college costs.
While no parent wants his or her child to graduate with crushing debt, remember that retirement planning ought to come first. While young adults have their entire lives and careers to look forward to – and decades to pay back debt – parents do not have that option. There are very few, if any, loans available for retirement!
It is becoming more and more important to begin saving for your kids’ college tuition when they are young. While the official inflation is just over 2 percent, tuition costs have been climbing consistently at a rate of approximately 6 percent annually. (Based on average tuition and fees for 2014-2015 as reported by The College Board® and assumed to increase between 5% and 6% annually.)
Costs for higher education have significantly outpaced inflation despite three steep recessions in the past 20 years. In the United States, as elsewhere, higher education continues to hold the promise of better career opportunities, better lifetime salaries and an upwardly mobile lifestyle.
Following is a list of ways to save for your child’s college expenses. Keep in mind that all of them have pros and cons, and not all of them may be right for your situation.
529 College Savings Plan
May 29 (5/29), also happened to be National 529 College Savings Plan Day. 529s are named after section 529 of the IRS tax code. These college savings plans offer a tax-friendly way to save for qualified higher-education expenses. Plans are generally sponsored by individual states, while investment firms or state government agencies manage the plan assets. There is no income limit for opening a 529, and anyone can open a 529 plan. Individual contributions top out at $15,000 per year, $30,000 per year for a married couple, without triggering a gift tax.
They can be self-managed or adviser-managed through your financial adviser.
Generally, it is a good idea to consider your own state’s 529 plan while also evaluating plans from other states. Some states offer a tax deduction and other benefits toward the amount contributed each year for residents. You can live in one state but invest in the 529 plan of another state if you decide that state’s 529 plan best suits your needs.
It is important to note that the gains in a 529 plan are tax free if they are used for qualified education expenses. If not, the gains are taxable and with a 10% penalty for use on non-qualified purposes. There are some concessions however, if the child gets a scholarship, there is a disability and some other exclusions for the 10% penalty.
So, what if the child does not want to go to college? The 529 plan offers flexibility. While the child is the beneficiary, the parent (or grandparent) is the trustee. The beneficiary names can be changed to other family members (even to the trustee/parent). If there is money left over after the child graduates from college, the remaining funds can grow tax free for further higher education in the future (a Master’s degree or Phd perhaps) or it can continue growing for the next generation.
Coverdell accounts
Coverdell Education Savings Accounts offer tax-free withdrawals for higher education.
Unlike 529 savings plans, withdrawals can be used for elementary and secondary education as well as for tutoring and education-related computer expenses. There are income restrictions, though, and annual contributions are limited to $2,000. It is possible to contribute to both a 529 and a Coverdell plan at the same time.
Custodial accounts
Uniform Gifts to Minors Act and Uniform Transfer to Minors Act are custodial accounts wherein the amounts transfer to the child and become his or her assets to spend as they see fit when they become adults. Contributions are irrevocable.
The funds can be used for college expenses as well as other purposes. 529 assets, on the other hand, can only be used for college education. The child will take control of the account upon becoming an adult (age 18 or as defined in the state you reside), and you need to be sure that you are comfortable with that.
Prepaid college plans
Private colleges in the U.S. offer a prepaid plan. You buy “tuition credits” at timed intervals or pay a lump sum based on the amount you want to invest. That locks in tuition at that year’s costs, as tuition and expenses 10 years later are, in all probability, going to be much higher.
Life insurance
Some strategies involve the use of universal or cash-value life insurance for the parents. Tax-free income may be withdrawn during the child’s college years and potentially again later in the parents’ retirement years.
While life insurance can be a viable income-generation strategy, it is usually more complex and may have higher built-in costs. Make sure to consult with a qualified financial adviser to understand the pros and cons of this approach.
Note: This write-up is for educational purposes only and should not be considered financial or tax advice. For questions, please reach out to Arvind Ven: 408.725.7122 or arvind.ven@lpl.com.
Arvind Ven is a Registered Representative with and Securities and Advisory Services offered through LPL Financial, a Registered Investment Advisor. Member FINRA & SIPC. Financial planning offered through Capital V Group, a registered investment advisor and a separate entity from LPL Financial.
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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