April showers bring May flowers… and graduations! It is hard to believe that another school year is wrapping up. As 2017’s high school seniors prepare to graduate and head to college this fall, they and their families will be thinking about how to cover these ever-increasing costs. College tuition has continued to rise faster than inflation over the past few decades, and it does not look like it is slowing down. A child born this year is projected to pay over $215,000 for a four year public in-state college when they are age 18.
There are many options for students to cover these expenses, including scholarships, financial aid from their college, and public and private loans. Anyone who thinks they may qualify for financial aid should fill out the Free Application for Federal Student Aid (FAFSA). To be considered for federal student aid for the 2017-2018 award year, you can complete a FAFSA between now and June 30, 2018. Any corrections or updates must be submitted by September 15, 2018. You can find more information about the FAFSA by visiting https://fafsa.ed.gov/.
The best way to cover the increasing costs of higher education is to start saving early. Here are three good options available for saving for college:
The most common savings vehicle for college is a 529 account. In this state-run savings program, your money grows tax-free until funds are withdrawn and used for qualified expenses. 529 savings can be spent on tuition, room and board, fees and textbooks at any accredited college, vocational, or trade school. Here is a more complete list of qualifying expenses from the IRS: https://www.irs.gov/publications/p970/ch08.html
Anyone can open a 529 for a child, but it is important to know who owns the account. The opener of the account can name any beneficiary, which is helpful because parents’ assets are not penalized as severely as student assets when it comes to determining federal student aid eligibility.
Another great feature to 529 plans is the high contribution limit. Amounts contributed to a designated beneficiary’s 529 account are treated as a gift. However, contributions of up to $14,000 can be made for each designated beneficiary without incurring federal gift tax. Also, an individual may be able to contribute a lump sum that covers five years, giving a total of $70,000 ($140,000 for married couples), provided the individual makes no additional gifts to that designated beneficiary for the five-year period.
The biggest drawback to a 529 is over-funding. If you do not use 529 funds for qualified expenses, you must pay tax and a 10% penalty on any earnings. This fee can be avoided by transferring the beneficiary to another family member that needs the money for college. For example, if your child finishes school with money left in their 529, you could transfer it to a sibling or even save it for a future grandchild to pass on a legacy of higher education.
What happens if your child receives a scholarship? First off – congratulations!! You would be eligible to withdraw the amount of the scholarship and avoid the 10% penalty for non-qualified expenses. You will still need to pay taxes on the earnings on the account, but you have already paid taxes on the contributions, so you are in the clear there. It can be comforting knowing that if your child does receive a scholarship, you won’t be penalized on that amount.
Coverdell Education Savings Accounts (ESA)
Just like a 529 account, an ESA offers tax-free earnings growth and withdrawals when the funds are spent on qualified education expenses. The advantage of an ESA over a 529 is that any K-12 expense is allowed, including required expenses like uniforms, laptops and even internet costs. Also, the effect on financial aid is the same as that for a 529 account.
The biggest drawback to an ESA is the low contribution limit. Contributions to ESA’s cannot exceed $2,000 annually, and that number is phased out if your income surpasses IRS thresholds (currently $190k for married filers). This limit is per beneficiary, not per contributor, meaning only $2,000 can be contributed for the child’s benefit per year, no matter how many accounts there are for that child. Also, similar to a 529 account, non-qualified distributions incur a 10% fee and tax on any earnings.
Uniform Transfers to Minors Act accounts (UTMA)
An UTMA can be very appealing since there are no education requirements for expenses. This means if a child ends up not pursuing higher education, there are no penalties for withdrawing funds. UTMA accounts are simple to set up and can invest in virtually any asset, including mutual funds, stocks, and bonds. You can even invest in real estate!
These accounts have an adult custodian who controls the money—how it is invested and spent—until the child reaches the age of majority. The legal age in most states is 18 or 21, although some states allow UTMA custodianship to continue to age 25.
Because money placed in an UTMA account is owned by the child, earnings are generally taxed at the child’s—usually lower—tax rate, rather than the parent’s rate. The first $1,050 of annual earnings is tax-free. The next $1,050 is taxable at the child’s tax rate, which is often 0%. Any earnings over $2,100 are taxed at the parent’s rate, which can be very tax-punitive, so you will want to be aware of what kind of taxable dividends and gains the account is generating. There are no annual contribution limits, although any deposits over $14,000 per person, per year, may be subject to a gift tax.
One downside of an UTMA is that it is considered an asset of the child, and the income the account produces (including dividends or interest) will be taxed as income to the child. This is usually at a much lower rate than the parents, but this becomes a bigger factor when you look at financial aid. The money in an UTMA can reduce a student’s financial aid eligibility by up to 20%. This means that if a student has $100,000 in this account, their eligibility would be reduced by $20,000.
In conclusion, there are several savings options available and depending on your family’s circumstances, any one or a combination of these could help you meet your child’s college financial goals. Similar to saving for your retirement, the sooner you start working on this goal, the faster your money can grow, and the more prepared you will be come graduation day!