Planning for Future Education Expense

Families that intend to send their children to U.S. universities for higher education face significant and rapidly increasing costs. The U.S. remains one of the most expensive education markets in the world, where the parents of a child born today can expect to spend more than $500,000 USD for four years of private undergraduate education. In addition to high costs today, the cost of tuition in the U.S. has increased nearly twice the pace of inflation. We recommend parents assume a 4-6% rate of inflation or more each year. Fortunately, there are some tax advantaged options for saving towards this goal.

529 Savings Plans

College savings accounts called 529 savings plans allow investors to make contributions to an account for future higher education expenses. These plans, sponsored by individual states, offer plan no tax deduction, but contributions grow tax-deferred and qualified distributions are tax-free. 529 plans are the most common and usually the most tax efficient option for setting aside funds for education.

Contributions can be made by parents, grandparents, other relatives, and even friends. The account owner controls the account and the distributions, unlike a custodial account where the child has ownership of the assets when they become an adult. Gifts to a 529 plan can be part of an efficient gift and estate tax planning strategy, and 529 plans can qualify for accelerated gifting. Accelerated gifting through a 529 plan allows investors to make a single gift of up to $150,000 for couples filing jointly ($75,000 for individuals) per Beneficiary — five times the annual gift tax exclusion — without any federal gift tax consequences.

Distributions are federally tax-free if the funds are used to pay for qualified higher education expenses including vocational schools, community colleges, traditional universities and graduate education. These expenses include tuition, room and board, books, fees and supplies. The distributions from 529 education savings accounts can be used at any accredited university in the U.S. as well as some qualifying institutions abroad. Recent tax reform now allows up to $10,000/year in 529 withdraws for primary and secondary school tuition. However, if funds are withdrawn from the plan to use for other purposes that are not qualified education expenses, the distribution will be subject to income tax and a 10 percent penalty.

If the beneficiary decides not to attend college, the investor can change the beneficiary to another family member or distribute funds to themselves for qualified expenses. Although Americans living abroad might not be considered residents of any state, they can still open a 529 savings plan because no state places residency restrictions on 529 account owners. We recommend investors look for a plan with low costs and range of quality investment choices.

Coverdell Education Savings Accounts

One other method of saving for education costs for families with lower incomes is a Coverdell Education Savings Account (ESA), formerly called education IRAs. Annual contributions of up to $2,000 are allowed per child. Parents, grandparents, other relatives, friends, and the child for whom the account is established can contribute to a Coverdell ESA.

However, these have limited applicability as once the donor’s Adjusted Gross Income is over $190,000 on a joint return or $95,000 on a single return, the donor starts to become ineligible to contribute.
Coverdell contributions are not tax-deductible, like 529 plans. The capital gains, dividends and income are tax-free. Distributions are tax-free if the money is spent on qualified education expenses. Coverdell funds can be used for K-12 tuition as well as expenses including books and supplies.

If the child does not attend college, the money must be withdrawn on or before the child turns 30. Then any earnings are subject to income tax and penalties. Unused funds can be transferred tax-free to a Coverdell ESA of another member of the beneficiary’s family who has not reached the maximum age of 30.

Roth IRAs

While not typically recommended, it is possible to use funds from a Roth IRA for education expenses. Qualified education expenses are an exception to the early withdrawal penalty. If you use a Roth IRA withdrawal for qualified education expenses, you will avoid the 10% penalty, but you will still pay income tax on the earnings portion. Your Roth IRA account balance is made up of contributions and earnings. You can always withdraw the contributions tax-free and penalty-free at any time, for any reason, because you have already paid tax on that income. Not so for the earnings portion. In certain jurisdictions, it may make more sense to use a Roth versus a 529 plan based on local tax rules.

Custodial Accounts (UGMA/UTMA)

The Uniform Gifts to Minors Act (UGMA) provides a way to transfer financial assets to a minor without the time-consuming and expensive establishment of a formal trust. Also referred to as custodial accounts, these are an option for setting aside funds in the child’s own name. A UGMA account is managed by an adult custodian until the minor beneficiary comes of age, at which point he assumes control of the account.

UGMA accounts can be opened through a bank or brokerage institutions. Friends and family can make contributions to the accounts, which carry no contribution limits or income limits. These deposits are irrevocable—they become permanent transfers to the minor and her account.

Typically, UGMA assets are used to fund a child’s education, but the donor can make withdrawals for just about any expenses that benefit the minor. There are no withdrawal penalties. However, because UGMA assets are technically owned by the minor, they do count as assets if they apply for federal financial aid for college, possibly decreasing their eligibility.

Maximizing Investment Returns Through College Savings Accounts

Most US taxpayers wanting to support higher education expenses for their children, grandchildren or other relatives can benefit from education planning, particularly if they are in a high tax bracket. However, education planning is usually only one piece of the financial puzzle and we encourage families to consider college funding as part of their overall financial plan. Our team of experts can help you determine what education solutions best meet your needs and help you incorporate this into your other long-term goals.