It is that time of year again when millions of young Americans begin returning to college. While it is certainly a time of excitement for students and a source of great pride for their parents, the costs of sending a child to college have been rising steadily for decades (about 8% annually). Texas parents who send their kids to an in-state college can expect to pay between $25,000 – $30,000 per year for tuition and room and board and double that amount for out-of-state colleges. Fortunately, there are options available to help supplement the costs, like scholarships, grants, and low-interest loans. Still, the majority of parents expect to pay for at least some, if not all, college costs out of pocket. Thus, it is very important that parents start thinking about financial planning for college. Most important would be saving for their kids’ college as soon as possible so the funds will have time to grow and hopefully keep up with the rising costs.
Saving for College
There are several types of college savings accounts, but the most common and flexible is the 529 education savings plan. 529 plans are legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions, and are authorized by Section 529 of the Internal Revenue Code. Texas residents can not only open an account through the Texas program but can also open a 529 account through any state in the U.S. 529 accounts are typically opened by parents or grandparents on behalf of a child or grandchild, who is the account’s beneficiary.
Most 529 plans offer a variety of investment options in equity and fixed income mutual funds and ETFs. If available, the best option may be to choose the plan’s “age-based” portfolio, which will start off investing the contributions more aggressively in equities for younger beneficiaries seeking higher growth. As the child gets closer to starting distributions for college, the investments will gradually shift from equities to less volatile fixed-income investments. If you have questions about the best investment options to choose for your 529 accounts, please reach out to us. At ML&R Wealth Management, we typically open these accounts as a courtesy for our clients who want them for their kids or grandkids, and we are happy to answer your questions.
Contributions to 529 accounts are made with after-tax money (similar to Roth IRAs), so you don’t get to deduct them from your federal taxes. However, one of the biggest advantages of 529 plans is that distributions used for qualified education expenses are not taxable. Qualified education expenses include things like tuition, room and board, class fees, computers, and internet access. While 529 plans originally could only be used for college costs, account owners can now use up to $10,000 annually per beneficiary for K-12 private school tuition.
If 529 account distributions are not used for qualified education expenses, the earnings portion of the withdrawal is taxed at the account owner’s ordinary income tax rate, plus a 10% penalty. The principal contribution portion of a 529 account can always be withdrawn tax and penalty-free for any reason. If there is money left in the account when the beneficiary finishes college, and the beneficiary does not need to save the balance for graduate school, the owner can change the beneficiary to another family member. Also, the SECURE Act (passed by Congress in 2019) allows 529 funds to be used for up to a lifetime limit of $10,000 in student loan repayments.
Another big advantage of 529 plans is that anyone can contribute to a beneficiary’s account, not just family members. Any number of individuals can contribute up to $15,000 a year to a beneficiary’s 529 account without having to file a gift tax return. This makes 529 accounts a great savings vehicle for family members to contribute to, especially if they want to get money out of their estates for estate planning purposes. If an individual contributes more than the annual gift tax exclusion amount of $15,000, the excess counts against their lifetime estate and gift tax exemption amount (currently $11.58m). Generous donors also have the option of “super-funding” a beneficiary’s 529 account, which involves an individual donating a lump sum of five years’ worth of lifetime exclusion gifts (5 X $15,000 = $75,000 total). In these cases, the donor would need to file the informational IRS Gift Tax Form 709 to apply the gift towards the donor’s lifetime estate and gift tax exemption amount.
Borrowing for College
While it is advantageous to save as much money for college as possible, parents have other priorities to consider and cannot always cover 100% of college costs through savings alone. For instance, parents should not completely forego their own retirement savings at the expense of college savings. You cannot borrow or receive grants or tuition to fund your retirement as you can with college. It is also important not to overfund 529 accounts, to avoid being taxed or penalized if you withdraw leftover money not used for qualified education expenses.
If a parent’s savings do not cover the entire cost of college, and the student does not receive other financial aid, the best option may be to take out student loans to make up for the shortfall. Student loans can come from the federal government, banks or financial institutions, or other organizations. It is important to fully understand the terms and conditions, and who is providing the loan. Student loans made by the federal government tend to have better, more flexible terms and rates than private loans. For instance, government loans have fixed, often lower interest rates, more flexible payment options after the borrower graduates, and potential loan forgiveness for graduates who work in public service. This webpage published by the Department of Education is a good resource for more detailed information on student loans.
Obviously, all parents want their kids to be happy and study subjects in college that are of interest to them. However, in addition to financial planning for college, it is also important for parents to try to educate their kids about money, and encourage them to pursue a degree that will likely lead to a career that may justify the high cost of college. College graduates have enough on their mind deciding where to live and work; it would be nice not to at least have the ability to use their degree to get a good job and pay any loans off in a reasonably timely manner. A new report from a public policy think-tank Third Way indicates that almost two-thirds of the 26,000 bachelor’s degree programs in the study enabled a majority of their graduates to make enough money to recover their costs in 10 years or less after graduation.
There are many things to consider when financial planning for college. With careful planning and an early start on saving, you can help make your child’s college education as successful as possible. As always, please reach out to one of our financial advisors in Austin if you have any questions about financial planning for college or any other financial matters.