How do you save for your kids’ college expenses?
By Jake Preston
The average cost of college in the United States per student per year is $35,551 in 2022, a cost that has more than doubled in the 21st century. Statistics also show that almost 16 million students were enrolled in undergraduate programs nationwide in 2020, more than 40% of the U.S. population aged 18-24. As a result, college planning is a vital part of many families’ financial plan; however, without careful thought and advanced planning, the paying for college can easily become quite stressful financially.
The goal of this blog is to provide a basic overview of various tools available that can be used in the college planning process. We will also discover the advantages and disadvantages of those vehicles to help you better understand which might fit your financial situation.
Before discussing the funding vehicles, it is important to note that financial planning, at its core, is about prioritization. The act of planning your finances involves allocating limited resources to an unlimited number of available options. As a result, prioritization is vital. Parents should understand that their financial lives take precedence over their children’s college education. Similar to how airlines recommend passengers secure their own oxygen mask before helping others (how can they help others if they are unable to breathe themselves?), parental financial security, both in the present and in the future, is the best way to ensure a stable home for their children. All decisions surrounding paying for college should be made with this in mind.
That caveat noted, let’s discuss the various tools available for funding education expenses.
A brokerage account is an account held at a custodian (i.e. Fidelity, Charles Schwab, Vanguard, etc.) that can be invested in individual stocks, mutual funds, and ETFs. This type of account is advantageous for paying educational expenses for a couple of reasons.
First, this account is extremely flexible. Money can flow freely in and out without restriction. Unlike an IRA or 401(k), there are no penalties for making withdrawals before a certain age. And unlike 529 plans, there are no penalties for using funds to pay expenses not related to college. Brokerage accounts are foundational to many financial plans.
Second, because the brokerage account is held in the parents’ or grandparent’s name, they retain full control. This alleviates concerns that students could use it for other purposes if they decided not to go to college.
A disadvantage to using brokerage accounts to pay for college is the lack of a tax-free benefit. While investment gains in this account for positions held at least one year are taxed at preferential long-term capital gains rates (ranging from 0-20% based on other sources of income in 2022), when compared to other funding vehicles like 529 plans, this account will likely be taxed at a higher level.
Custodial Brokerage Account (UGMA/UTMA)
A custodial brokerage account is identical to a brokerage account (held at a company like Schwab, Fidelity, or Vanguard) with the only difference being that it is owned by the child. The “custodial” means that the parent (i.e. the custodian) is responsible for managing the account for the benefit of the child while he or she is under a certain age (18 or 21 in most states).
There are laws in existence that dictate how these accounts work. The laws are referred to as the Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA). While the laws vary from state to state, they govern how the custodial brokerage account is handled.
One benefit of a custodial brokerage account is that there is a modest tax benefit. The growth and income generated from the holdings (stocks, mutual funds, ETFs, etc.) are taxed at the child’s ordinary income rate which is likely 0% since most children do not have any other income.
Another benefit is flexibility. While the account cannot be used to pay for expenses unrelated to the child, it can be used to pay for anything benefitting the child such as K-12 tuition, vacations, gear for sports, etc. There are no restrictions on its use as long as it benefits the actual owner of the account, the child.
A disadvantage of a custodial brokerage account is the fact that the account will become solely owned by the child at either age 18 or 21 (varies based on the state). At that point, the child can legally do whatever they want to do with the funds in the account. If the parent has been contributing money due to the tax benefit and plans for the money to be used for college, the child could decide to use it on a new car instead and the parent would have no legal recourse.
A second drawback to a custodial brokerage account is that it may impact college financial aid. If you are planning to seek federal financial aid, the FAFSA considers 20% of funds in this type of account to be available to pay for college. With that in mind, this is likely not the best account to be used for college.
The word “plan” can be a bit deceiving here as it is more accurate to think of a 529 as just a type of account designed to be used for college. A 529 plan can be established for anyone (doesn’t have to be for a child) who wishes to save money in a tax advantaged way for college.
The first and largest benefit to using a 529 to pay for college is for the tax benefit. After-tax money is contributed to the account, and it grows indefinitely tax-free. It is similar to a Roth IRA, but instead of being used for retirement and the restriction for distributions having to do with age, a 529 is used for college and the restriction relates to use of the funds – i.e. to pay educational expenses. There may be additional tax benefits depending on your state of residence as many states offer tax credits or deductions for contributions to their state’s 529 plan.
Another advantage to a 529 plan is that there is no income limit. High-earning parents or even grandparents can make contributions to an account for the child planning to go to college.
The final benefit is that the contribution limits for 529 plans are extremely high. To put it simply, you can contribute no more than the amount necessary to provide for the qualified higher education expenses of the beneficiary. This means that you can fully fund a child’s college education through a 529 plan and receive a generous tax benefit.
The largest drawback to 529 plans is obvious: they can only be used, without penalty and/or taxation, for educational expenses. Let’s say a family saves $100,000 for a child’s college education, but the child decides not to attend college. In most circumstances, the parents may face taxes and penalties for withdrawing money from the account and not using it for educational expenses. However, one way to combat this disadvantage is to simply change the beneficiary, either to another child or to someone else in the family who plans to attend college.
One note: 529 plans are maintained individually by all 50 states. However, you do not have to open a 529 in the state you live or the state in which your child plans to attend college. Like brokerage accounts, 529 plans can be opened at companies like Fidelity and Charles Schwab; however, it should be noted that investment options are limited to what the state provides.
Coverdell ESAs used to be known as Education IRAs but were renamed in 2002. These accounts work much like 529 plans in terms of tax treatment (after-tax contributions, tax-free withdrawals for education expenses); however, one benefit to Coverdell ESAs is that an unlimited amount may be spent on qualified K-12 expenses including tuition, books, supplies, etc. (529 plans allow for a maximum of $10k to be spent on K-12 tuition).
Coverdell ESAs come with quite a few disadvantages. First, they have much lower contribution limits compared to 529 plans. Coverdell ESAs cap maximum yearly contributions per child at $2,000.
Another drawback is that any funds in a Coverdell ESA not used for college are distributed to the child. This is a significant disadvantage considering 529 plans allow the owner (parent or grandparent) to maintain control over the account indefinitely.
Coverdell ESAs also come with income limits for contributions. A married couple with more than $220,000 in modified adjusted gross income will not be allowed to contribute.
All the reasons above point to the significant decline in popularity and usage of Coverdell ESAs over the past few years.
The final education funding vehicle to consider is the Roth IRA. A Roth IRA is an account meant for retirement that allows for after-tax contributions up to a certain limit ($6,000 in 2022). Provided requirements are met (account open for at least 5 years and owner at least age 59 1/2), investment earnings can be withdrawn tax-free.
Most children will not have enough earned income to make this a worthy investment for college. However, there is a situation in which it could make sense as part of the college savings equation.
The only scenario where this would make sense for college is if one or both parents will turn 59 ½ during the college years. In this case, provided the account has been open and funded for at least 5 years, they could make withdrawals tax-free and pay for college.
While it is possible to use Roth IRAs to pay educational expenses in a tax-efficient manner, we recommend viewing IRAs as retirement assets and using vehicles such as brokerage accounts and 529 plans for funding college. Using Roth IRAs to fund college for children has the potential to draw needed funds away that were intended for retirement.
Planning and saving for a child’s college education is an important part of many families’ financial plan. However, it can be quite challenging to navigate the complexity and numerous variables involved in the process.
The primary goal of this piece was to help simplify the discussion by providing a basic overview and framework of the various savings vehicles used most often in the college planning process that provide both a financial benefit and flexibility.
Do you need help navigating the college planning process? Reach out to us at firstname.lastname@example.org or give us a call at (540) 345-3891 to set up an introductory meeting to discuss your situation and how we might be able to help.
Jake Preston, CFP® is a Christian financial planner in Roanoke, VA specializing in comprehensive financial planning and faith-based investing. In addition to serving clients, Jake is the Director of Advisory Services at Beacon Wealth Consultants where he oversees all aspects of financial planning for the company.