By: Connor Donovan, CFP®
With graduation season just around the corner, now is a good time to think about how you’ll pay for your child’s or grandchild’s college education. The rising costs of higher education can make financing college challenging even for affluent families — especially if you plan to send your children to private universities.
For example, the average cost of tuition and fees alone at a private four-year college now exceeds $32,000 per year, according to the College Board. But this is just the start — there are myriad other expenses such as housing, food, books, supplies and transportation that can easily double or triple this number.
The challenge is even greater for families with multiple children. So what can you do to help ease the financial burden of sending your kids to college?
529 Plans vs. Trusts
Many families use 529 plans to save money for college education expenses. These plans offer valuable tax breaks: Earnings grow on a tax-deferred basis and distributions are tax-free as long as the funds are used to pay for qualified education expenses such as tuition and fees, room and board, supplies, books and computers.
529 plans are offered by states, but you don’t have to live in a state to open a plan there, nor do students have to attend college in the state where their 529 plan is opened. Funds can be used to pay for qualified education expenses at most U.S. colleges, as well as some overseas universities and many vocational-technical schools. Another benefit of the 529 plan is that funds can be transferred between individual plans, which can be valuable if a parent has overfunded their older child’s plan and underfunded a younger child’s.
There are, however, a few drawbacks to using 529 plans to save for college. One of them is that there are only limited uses with the 529 funds. Funds can only be withdrawn for college expenses or up to $10,000 per year for K-12 private education tuition. This could be a problem if your child decides not to attend college or earns scholarships that end up covering most or all of the college costs. Also, many 529 plans offer fairly limited investment options.
One alternative is to use an irrevocable trust to save money for college. Certain trusts can be structured so that assets cannot be distributed for purposes other than education, maintenance, support and healthcare for your child. Also, trust assets can be invested in a wide range of different types of investment vehicles.
An irrevocable trust also offers estate planning benefits if your family is subject to the estate tax. You could fund the trust for the benefit of your child using your annual gift tax exclusion (currently $15,000). You can then make qualified transfers from the trust directly to the educational institution to pay for college expenses. By doing so, the transfers won’t count toward your annual or lifetime gift exclusion.
If there are any remaining assets in the trust after your child graduates, they can stay in the trust so they’re protected from creditors. This also protects assets from possible careless spending by your child. Of course, the biggest drawback to using an irrevocable trust to save for college vs. a 529 plan is that trusts don’t offer any tax benefits and, depending on the structure, may be subject to higher overall effective rates of income taxation. There are also legal and compliance costs involved with establishing and maintaining a trust. So you should weigh the potential benefits of a trust in your situation to the loss of tax benefits to decide which strategy is best for you.
Using Custodial Accounts for College
Custodial accounts are another tool used by many families to save money for college expenses. Commonly referred to as UTMAs and UGMAs, these accounts are set up by parents and grandparents for the benefit of their children and grandchildren. While they don’t offer tax-free growth or distributions, they do feature another important tax benefit: The earnings are taxed at your child’s presumably lower tax rate.
There are no annual contribution limits with custodial accounts so you can save as much money as you like for college each year. Keep in mind, however, that your child will assume control of the money when he or she reaches the age of majority (18 or 21, depending on the state). This can be for many one of the biggest potential drawbacks of using custodial accounts to save for college as opposed to 529 plans or irrevocable trusts.
Two Big Questions
Two common questions many families have when it comes to college savings are: When should we start saving for college? And how much money should we save each year?
The answers, in short: Ideally, you should start saving for college as soon as possible. In fact, many families start college savings funds for their children as soon as they’re born. This maximizes opportunities to take advantage of long-term compounding of returns.
As for the second question, there’s no one-size-fits-all answer. It depends on factors like what kind of college you want your child to attend (e.g., public vs. private, in-state vs. out-of-state), when you get started saving, how many children you have and what your other financial goals are — especially when it comes to retirement.
Mr. Donovan joined Simon Quick in July 2017. He is currently an associate on the client advisory team. He is responsible for supporting the Partners and Client Advisors in assisting with financial planning for clients, implementing investment plans, preparing investment performance reports and coordinating client communications. Connor completed the Financial Planning Certificate Program at New York University in December 2019 and became a CERTIFIED FINANCIAL PLANNER™ practitioner in July 2020. Learn more about Connor on LinkedIn.
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