Planning For Our Children

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Planning For Our Children

College expenses, tuition hikes and the rising cost of an education are all things you hear about when it comes to sending your children off for their undergraduate degrees, and in some cases, graduate degrees. The 10-year historical inflation rate for education related costs is approximately 5%1, while the 10-year average rate of inflation for non-education related expenses is much lower. This can be daunting to think about when it comes to sending your children off to college.  What does it really mean for you?  Don’t let it tempt you to say…forget it, they’re on their own!

In order to avoid that feeling of helplessness when it comes to such a critical stage of your child’s life, pre-planning is key. So, at this point, you may be asking, what is the best way to save for my kid?

  • Start now. Your money needs time to grow. As your investments appreciate, they will compound, which means your appreciation will appreciate too.
  • Set aside a consist amount of money that you want to save for your child on an annual or a monthly basis. For example, if you decide on $6,000 per year, you can do this all at once, or save $500 per month. The key is to choose a method that works for you and that you can stick with.
  • Tax-free. Yes, no taxes! 529 plans are a wonderful way to save for your children and allow you to take the money out free of any taxes, as long as it’s used for education costs.

529 Plans

Over the past few years, 529 plans have become the premier method of saving for college. The plans allow for tax-free growth, significant contribution limits and do not impose income limitations. In addition, the fees/expenses are very reasonable and the investment choices are as well, in most cases.

These plans are now the gold standard for college savings. They allow a much larger contribution amount than a Coverdell ESA (discussed below). The limit depends upon the state plan you choose. There are no age restrictions and some states offer additional tax incentives. Like Coverdell ESAs, if the funds are used for qualified education expenses, they will come out of the account tax-free. Unlike Coverdell ESAs, 529 plans do not have modified adjusted gross income limitations in order to participate.

Of course, it is not as simple as choosing a 529 plan. There are 2 types of plans. Please note that there are prepaid tuition plans and there are college savings plans, both of which are considered to be 529 plans. Prepaid tuition plans lock in the tuition at the state plan’s state school, allowing you to pay for future years of college at today’s costs. Since the inflation rate of education expenses is so high, this is essentially matching your investment rate of return with the rate of inflation for education expenses. The drawback to this type of plan is that your child is limited to the state school for that state’s plan.

College savings plans, on the other hand, do not lock in the tuition but give the beneficiary the option to use the funds at any institution. In a 529 college savings plan, contributions are allocated to specific investments selected by the account owner. The accounts value then depends upon the growth of the investments held in the account. Typically, these plans only allow the plan beneficiary to change investment allocation once a year. However, age-based allocations have become popular. They become increasingly more conservative as the child reaches college age. This type of allocation avoids the need to make ongoing investment modifications.

Choosing a 529 plan can involve a bit of research, depending upon your personal preferences. There are a few sources that have researched and ranked state plans based on investment choices and fees.

  • Morningstar – Morningstar assigns ratings based on 5 pillars: Process, People, Parent, Price and Performance.  Morningstar also takes into consideration other unique benefits, including local tax breaks, grants and scholarships.
  • Savingforcollege.com – Analyzes investment performance and ranks based on the “performance score.”

Once you get past that hurdle of selecting a state plan, you’ll be well on your way to helping fund your child’s education.

529 Plan Quick Facts

Contribution Limits:

  • Contributions of up to $14,000 per year may be made to a 529 college savings plan without triggering any gift taxes. This amount matches the annual gift tax exclusion for 2016, which is indexed annually for inflation.
  • Contributors may choose to make accelerated gifts lumping 5 years of gifts into one year (under IRC Section 529(c)(2)(B)), allowing a contribution of up to $70,000 to a 529 plan beneficiary in a single year, prohibiting additional gifts to the account over the next 5 years.

Qualified Expenses:

  • Contributions may be withdrawn tax-free when used for qualified higher education expenses, including tuition, room and board, fees, books, supplies, and equipment, including computers.

State Tax Benefits:

  • Some states offer resident participants of their plan an incentive to choose their plan by giving a state tax deduction for a portion of the contribution amount (up to a set limit). Please note that this only applies to in-state participants, and California does not offer such incentive tax benefit.

Maximum Age:

  • There is no maximum age for contributions, and there is no maximum age for funds to remain inside the plan as well. Funds that do not end up being needed for a beneficiary can be used for another beneficiary who is a family member of the original beneficiary.  For example, if a scholarship is received by a beneficiary, the funds in the account can still be used by another family member.  If the funds are not ultimately used for eligible educational expenses, then any growth in the account is taxed as ordinary income and is subject to a 10% penalty.

Financial Aid:

  • Funds in a 529 plan are treated as an asset of the parents, regardless of whether they are owned by the parent or the child. If the child is not a dependent, however, then the account will be treated as an asset of the child.   If the 529 plan is owned by a grandparent, it is not included in the financial aid evaluation, however, distributions from the plan count as income of the beneficiary for purposes of the Free Application for Federal Student Aid (FAFSA).

Coverdell ESAs

Another option to 529 plans are Coverdell accounts, but their implementation is much more limited.

A Coverdell ESA (previously known as an Education IRA) allows you to contribute up to $2,000 per year per beneficiary as long as your modified adjusted gross income does not exceed $95-110K for single filers or $190-220K for married filing joint filers.  The $2,000 limit is phased out and then capped for people within these income brackets.

The advantage to Coverdell ESAs is that the funds can also be used for grades K-12.  The funds will be tax-free if used for qualified education purposes.  The disadvantage is that the funds have to be made for a child under the age of 18 and used by the age of 30.  Also to be noted, you can make this contribution until April 15th for the previous calendar year.

Conclusion

The first thing to keep in mind when saving for your child’s college education is to take some pressure off of yourself and just do the best that you can.  Paying for some of their college bill would be better than none of it.  Rest assured, many parents are in these shoes.  With tuition costs rising faster than inflation and faster than our paychecks, we do not have too much of a choice.  However, there are some great ways to save for college that do not include stuffing money under your mattress.  You can get your money to work for you and take advantage of the tax benefits that are available.  Win win.

Footnotes

1The College Board® https://www.collegeboard.org/

Disclaimer

Callan Capital does not provide individual tax or legal advice, nor does it provide financing services. Clients should review planned financial transactions and wealth transfer strategies with their own tax and legal advisors. Callan Capital outsources to lending and financial institutions that directly provide our clients with, securities based financing, residential and commercial financing and cash management services. For more information, please refer to our most recent Form ADV Part 2A which may be found at http://www.adviserinfo.sec.gov.

By | 2017-06-02T17:58:52+00:00 November 4th, 2016|Financial Planning|

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