If you are a new parent like me, you are probably always thinking about your child’s future, whether it be the “what the hell we are going to do tomorrow? I am running out of quarantine activities!” Or thinking longer-term about what your child’s life will be like as they grow up, what schools should they attend in grade school? This train of thought leads to the inevitable idea of paying for college.
Some of us might still be paying for our college! How are we going to pay for our child! Education planning is a daunting financial concern for many people.
The harsh reality is the cost of college is increasing at an astronomical rate. Since 1983, college tuition has risen by 798% averaging 6.3% inflation per year. With this wild rate of inflation, projecting out the future cost of college for younger children is not an exact science. However, estimates for a 1-year-old to attend 4 years of the public in-state college range from $167,684 to $295,496. If we are considering a private college, those numbers range from $395,783 to $599,883.
While these numbers are flat out terrifying for many parents to visualize, however, there is some good news. There has been an increase in public outcry over tuition inflation. The political momentum to at least slow the rate of inflation or help lower costs is picking up steam, and the recent COVID-19 has forced many institutions to reconsider how they deliver their education. So perhaps by the time our toddlers reach college-age costs won’t be as high as these projections and maybe they do some or all of it virtually?
Is College Even Worth It?
A common criticism I hear from parents is that they don’t know if their child will attend college. The world is changing, and it is hard to project what the future will look like in 3 months, let alone 18 years.
While I agree, it is hard to project what the future holds, there are a few critical facts that are true right now, and likely for the next few years. First, average annual earnings for someone with a Bachelor’s Degree is 83% higher than someone without one. People with professional degrees average 157% higher pay. So we know it pays to attend college right now, and probably for the next 5-10 years. Second, as of August 2019, only 3.8% of recent college graduates are unemployed compared to 6.5% of young workers without college degrees. COVID-19 will likely skew these numbers, but as companies begin to rehire and ramp-up, the gap is likely to widen. So we know having a college degree reduces your child’s risk of unemployment significantly. Lastly, we know that for the class of 2018, the average starting salary was 13.4% higher than for the class of 2013. Yes, the economy has been strong during that period, but higher-earning majors drive much of this increase in starting salaries. The highest starting salaries were graduates who majored in Computer Science, Engineering, Math and Statistics, Health Care, and Business. So we know helping our kids choose in-demand majors increases the ROI on the cost of college. As a parent, these facts are hard to ignore and certainly make the case that planning for college should be a priority for all parents.
Household Financial Priorities
I often use the analogy of flying on an airplane when talking with families about prioritizing education planning and all other financial goals. We all know that if you are on a plane, and those air masks come down, you put your mask on first and help your kids second. The same principle holds true here, you need to make sure your finances are in order before you can think about supporting your kids.
This means you should reduce household debts such as credit cards and student loans. You should be on track for your retirement goals and have a steady savings plan and emergency fund already established before considering educational planning. The debt is a drag on household savings. You can take out loans for your child’s education, but you cannot take out loans to fund retirement, and you always want to have an emergency fund to protect the household from unexpected financial hardship.
Explaining 529 Features and Benefits
A 529 plan is a state-sponsored education savings plan that offers tax and financial aid benefits. These benefits vary state to state, but in general, if your state has an income tax, your state 529 has income tax incentives. Investments grow tax-deferred, and distributions used for qualified educational expenses are tax-free. 529 plans can pay for both k-12 education in addition to college costs. This creates a very tax-efficient savings vehicle for families planning for children and relatives education. The plan contribution limits are $15,000 per individual per year. Married couples can put in $30,000, grandparents, and loved ones can put in additional funds. Anyone who lives in the state that sponsors the plan would be eligible for any tax benefits, which is a common estate reduction strategy for grandparents.
The assets in the 529 remain in the custody of the parent, grandparent, or guardian of the child. So as the child gets older, they cannot just spend the funds as they see fit. Beneficiaries of the 529 can change, meaning families with multiple children can change which child is the named beneficiary based on changes to financial circumstances, financial aid, and a myriad of other factors.
Restrictions of 529s
The most common drawback of 529s I hear about is the requirement that the funds must be spent on what the IRS deems as qualified expenses or you will incur penalties. So what happens if your child does not go to college? As I mentioned earlier, the beneficiary can change to another child, family member, or loved one.
But if it makes the most sense to spend the 529 for other reasons, for example, an only child, there are several important rules to understand. First, almost all states allow you to withdraw the principal amount (any direct savings deposits made into the account) without penalty. So that portion of the funds gets returned tax-free no questions asked. If you withdraw the earnings and growth for non-qualified expenses, that distribution would be subject to a 10% penalty and income taxes. To this point, I would highlight the tax-free growth you have experienced during the savings years will more than offset that 10% penalty depending on how long you have been saving in the 529 and the market returns in that period. The last remaining item to address is the income tax liability on non-qualified 529 distributions. If the distribution goes to the child, it is taxed at that child’s income tax rate. The few times I have been involved in this type of event, the 529 was used to pay for the child’s rent and basic living expenses while they did unpaid internships. In those cases, we strategically withdrew amounts to keep the child in the 0% income tax bracket. To summarize, I don’t view this lack of portability as a real drawback if you consider the tax benefits over a few years of investment growth. As Dave Chapelle once said, “modern problems call for modern solutions,” and there are many solutions to this obstacle.
Alternatives to 529s
Taxable Investment Accounts
You can invest in a fully taxable account. This would mean paying capital gains taxes on the investments, and if your child ends up going to college, you would need to save substantially more than you would in a 529 due to those capital gains taxes.
Uniform Gifts to Minors Account or Uniform Transfer to Minors Accounts were the primary method of savings before 529s were created in the 1990s. The significant downsides are they are fully taxable but at the child’s rate. So it would be more tax-efficient than the taxable account in the parent’s name, but less efficient than a 529. More importantly, the money put in these accounts is irrevocable, meaning once the child reaches “the age of majority,” each state is different. Generally, the age of majority is 18-21, it is their money, and they can do whatever they want with it. The last drawback is when it comes to applying for financial aid, the 529 is considered the parent’s asset, but UGMA/UTMA would be viewed as the child’s asset and would weigh more heavily when determining financial aid needs.
A Roth IRA
While it is a vehicle primarily designed for retirement, it can be used for education costs. First, it is essential to remember the airplane analogy, you must take care of yourself before you can help others. So once you are maxing out your 401k or employer-sponsored retirement plan, have an emergency savings vehicle, and have decided you are ready to commit to educational savings, a Roth could be considered.
To qualify for contributing to a Roth IRA, you would need to have a joint income of under $206,000 or a single income of under $139,000. If you are at that income level, it might make sense to fund a Roth IRA instead of a 529, especially if you live in the northeast, California or another high cost of living area. The main reason I advise that is, if your cost of living is relatively high, it is not likely that income level would allow more than $12,000 annual savings for education. Roth IRAs are limited to $6,000 contributions per year. If you are married, both spouses could fund the Roth hitting that total of $12,000. This would provide the opportunity to use the funds for retirement or education. However, a Roth IRA limits contribution amounts by the parents and other family members cannot contribute to someone else’s Roth IRA. As household income increases, you may want to shift to a 529, and if you know other people want to contribute, a 529 would be a better option.
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I will continue to take a deeper dive into education planning in the future, discussing the various scholarships and grants and explain how financial aid works. If you are a family who is thinking about the daunting financial burden of your children’s education, hopefully, this can help clarify the choices you have to make and help you figure out what makes the most sense you and your family to begin saving. I am a firm believer in the 529s. In the last tax reform, they allowed 529s to be used for k-12 education. If there is a significant reform in higher learning and the delivery of college education, I am confident that Congress will continue to adjust the 529 rules to meet those changes and incentivize people to use 529s.
- JP Morgan College Planning Essentials Interactive Guide (JP Morgan sponsors NY State Plans if you are a resident of New York or you work in NYC this would be the plan you should consider for tax purposes)
- SavingForCollege.com. This is an excellent site for general knowledge, they have some helpful calculators and free resources.
Schedule a meeting with me. I am always happy to have a no-commitment conversation and provide a stand-alone projection based on your situation at no charge if you are trying to get started with your educational planning.