Let’s face it – higher education can be expensive.
According to the Education Data Initiative, the average annual cost of college, including books, supplies and daily living expenses, per student in 2023 was $36,436. And if you read the latest headlines, watch the recent news segments or are part of any social media group discussing college expenses, you know that it can easily be much higher.
As a parent of two elementary school-aged children college savings is squarely on my list of financial considerations and conversations on a regular basis. Whether you are a new parent, a grandparent or in the trenches with teenagers, if paying for college is part of your future story, planning for it should be at the core.
Callie Morgan, Regions Private Wealth Management planning analyst, shares the benefits of 529 savings accounts, one of the most common college savings vehicles in the U.S.
529s for College Savings
“There are a number of reasons that 529s are among the most popular college savings plans,” said Morgan. “Once a 529 plan is established, anyone can contribute to the account up to the annual gift tax limit without incurring gift tax consequences. Furthermore, beneficiaries may have more than one 529 saving plan. Although there are no income limits for contributing to the plan, each plan has a lifetime contribution limit which ranges anywhere from $350,000 to $550,000 depending on the state.”
The funds grow tax-free when used for qualified education purposes and have low impact on Free Application for Financial Aid Services (FAFSA).
Is There a Downside?
Morgan noted that investment options for a 529 can be somewhat limited and are typically target based, so tend to be more aggressive when the child is younger and switch to more conservative investments as the beneficiary reaches college age. And if the beneficiary decides not to attend college, the earnings portion of withdrawals from the 529 account are taxed as ordinary income and subject to a 10% penalty.
“The beneficiary can be changed as needed,” Morgan said. “However, if there is not another beneficiary who has eligible qualified education expenses, the tax implications are applicable on withdrawals.”
I tend to lean towards establishing a trust account for education purposes in cases where there is concern from the parent or guardian that the beneficiary child may not be sold on going to college.
Maya Brill, Private Wealth strategist, pointed out that when talking with clients about college savings plans, she likes to caution against overfunding a 529 account. This is especially important for those parents or guardians of only children where there isn’t necessarily a second beneficiary waiting in the wings to use any funds that would remain in the account should the original beneficiary decide to forego higher education all together.
“I tend to lean towards establishing a trust account for education purposes in cases where there is concern from the parent or guardian that the beneficiary child may not be sold on going to college,” Brill said.
For this reason, both Brill and Morgan recommend a mix of college savings vehicles and other financial accounts to their clients, depending on their individual financial situation and goals.
Looking Beyond the 529
There are other financial accounts that can be used for college savings, such as the Uniform Gifts for Minors Account (UGMA) and Uniform Trust for Minors Account (UTMA), which are set up for the beneficiary with the parent or guardian as the custodian until the beneficiary reaches the age of majority (either 18 or 21, depending on the state).
“With UTMA and UGMA accounts, parents and guardians can leverage the tax benefits under gifting rules, but once the beneficiary reaches the age of majority the funds become theirs to do with what they wish – and that may not align with what the parent or guardian had in mind when establishing the accounts,” said Brill.
Non-educational investment accounts and trusts can also be leveraged for college savings and offer greater flexibility should the beneficiary opt out of college.
“Investment accounts and trusts are valuable savings tools that may not come with the tax benefits of college savings accounts but don’t have the same rigidity in how the funds are ultimately utilized,” Brill noted. “We see clients who have children who decide not to go to college or have excess funds from investment or trust accounts originally earmarked for college that decide to provide those funds to their adult children for a down payment on a home, wedding expenses, or other milestones.”
Not everyone is eligible to contribute to Coverdell accounts because there is an AGI phase-out.
Another education-specific account is the Coverdell Education Savings Accounts (ESA). Similar to the 529, the investments grow tax-free, it has low impact for FAFSA and can be used for K-12 education expenses as well as college education expenses. One benefit of this type of account is that there is a wide variety of investment options, whereas the 529 options are limited. On the downside, Coverdell accounts come with income level restrictions and are limited to contributions of $2,000 per year, per beneficiary.
“Not everyone is eligible to contribute to Coverdell accounts because there is an AGI phase-out,” Morgan noted. “Additionally, contributions can no longer be made once the beneficiary turns 18 and funds must be utilized by the time the beneficiary turns 30.”
Any nonqualified withdrawals from a Coverdell are subject to ordinary income tax and a 10% penalty, so similar to the 529s, if the beneficiary chooses not to go to college, there are limitations to how the money can be used.
Is Prepaid Tuition Right for You?
Another interesting option that is available in certain states is the Prepaid Tuition 529. With this option, you can lock in the tuition rate for your chosen university well before the child is ready to go to college. If your child decides on a different university in the same state, that prepaid tuition can be rolled over. However, if they choose to go out of state, those funds are no longer applicable.
“Texas has prepaid tuition plan where you can pay in and it will cover two-year, four-year, or some private colleges,” Brill noted. “It is a commitment, and you are locked into approved schools in that state but is attractive in that you can commit to that at any age – which may lock in a much lower tuition rate than when your child is ready for college.”
College Savings: Planning for the Right Amount
With average annual increases of five-to-seven percent considering future tuition costs can be daunting. So, how do you know if you are saving enough?
“We use a planning software and generally aim to over-estimate the inflation cost,” said Morgan. “When we pick those education vehicles, we are looking for growth in the assets. And while not always ideal, loans and grants are available through the state and through the individual colleges to potentially make up for any deficits.”
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