Everyone is feeling the effects of higher inflation. Forbes reports even during the low-inflation environment pre-pandemic, the cost of a four-year college education was increasing at twice the rate of inflation. Put another way, between 1985/86 to 2017/18, tuition rose by 497 percent.
If your client’s child attends college, it will likely be a public (state) or private school. According to Thinkimpact.com, public schools averaged $21,035 for tuition and private schools were $32,769 for the 2019/20 school year.
Vanguard (and other financial services firms) offer calculators for projecting future college tuition costs. If your clients have a specific school in mind yet do not know the costs, tools like myintuition.org can help estimate current tuition costs at specific colleges, which can be used as a starting point for projecting future costs.
Your Client Knows College Will Be Expensive. How Can They Save?
Your client is already saving for their retirement through their 401(k) plan at work and other retirement accounts you have advised them to establish. They realize saving enough for retirement is a long journey, but they are able to invest in a tax-deferred environment. A similar logic should be applied to saving for their child’s college education.
The government has established Section 529 college savings plans for just this purpose. Your client can put money aside in a segregated account to provide for their child’s education and enjoy the benefits of tax deferral. Compared to their retirement account, these college savings accounts have an advantage and a disadvantage. The advantage is big: If the funds are used for qualified educational expenses, money can be removed free of federal taxes. Now for the disadvantage: Unlike the 401(k) plan that your client funds with pre-tax dollars, college savings plans are funded with after-tax dollars. Because it is funded with after tax dollars, 529 plans are often likened to a Roth IRA.
How Do 529 Plans Work?
Different states have different programs. Let us use New York State’s Advisor Guided College Savings Plan as an example. JP Morgan Asset Management is the investment manager. (In New Jersey, Franklin Templeton is the investment manager. In Maine, the investment manager is BlackRock.)
All 529 college savings plans have an owner and a beneficiary. The owner is the adult adding the money and managing the account. It can be a parent or grandparent. The beneficiary is the child who will be a student in school in the future. The beneficiary can be changed if the child does not go to college, but the new choice must be a family member.
Like an IRA account at a bank, you can open a 529 college savings plan with a small amount of money. You can also approach it from the other direction and invest up to $16,000 per individual (in 2022). Contributions over that amount count towards your Lifetime State and Gift Tax exemption. Five years’ worth of gifts can also be contributed in the first year and prorated over the five-year total. (So, you can contribute $80,000 now and consider it as one $16,000 current gift and four $16,000 future gifts.)
Your tax advantages do not stop at tax-deferred growth and tax-free withdrawals for eligible education expenses at accredited schools. Depending on your state, you may get a current state tax deduction from income. In New York State (NYS), advisor-guided plan holders can deduct $5,000 in contributions for single filers and $10,000 if filing jointly from their state income taxes.
Like your 401(k) plan at work, your plan provides a series of investment choices. The managed funds within each portfolio are selected by the investment manager. Fees are competitive. You can change from one investment option to another only twice per year or if the beneficiary changes.
Just be aware you cannot put an unlimited amount of money into the plan. The aggregate contribution levels vary by state. NYS has a contribution limit of $520,000 per beneficiary.
What Are the Advantages of 529 Plans?
In addition to the advantages mentioned above, there are many reasons your client should consider setting up this plan for their child immediately.
The following are just some of the most compelling ones:
1. They are easy to establish. Every state has a plan.
2. Financial aid calculations are unaffected. The amount of money the parent has saved does not work against them when financial assistance is calculated.
3. College isn’t the only option. Funds can be withdrawn tax free for qualified educational expenses. This includes K-12, not only college and advanced degrees. K-12 withdrawals are limited to $10,000 per year.
4. Ring fencing is attractive. When your child is born, some relatives might say: “We will help with college education.” However, they might not be eager to just hand over checks to parents on the chance the money will be spent on other things, like a family vacation. By establishing a 529 college savings plan, you can assure relatives any cash gifts they give now will be added to a segregated account to only be used for educational purposes. If a person other than the owner wants to contribute, check to see if your state allows it.
5. Paying down college loans. The monies within the college savings plan can also be used to pay off student debt.
6. The owner can access the money under certain circumstances. If your child doesn’t go to college and there are no educational expenses, the owner can withdraw the funds. They’ll have to pay income tax plus a penalty on the earnings, though.
A variation on the college savings plan is the prepaid tuition plan. Some schools allow you to pay for a future college education at the current price of the school’s college credits today. This is different from a College Savings Plan because there are no investment options. It’s a way of paying today’s prices for an education to be delivered in the future. That’s a subject we can address in detail at another time.
Your client knows they must plan for retirement. They should give the same attention to the future education costs for their children.
