Saving for a child’s college education is a major planning objective for many families. The unfortunate truth is that the cost of higher education has risen rapidly over the last few decades. Projections like the one below illustrate the potential future cost of higher education:
Even after taking into account the average net cost of higher education after financial aid awards, the overall price of a college education remains daunting:
One of the best ways to help prepare for these future expenses is by saving now for your future education goal:
There are many strategies to consider when determining how to best cover the cost of higher education. Here are five:
1. Direct Payment to Educational Institution
The Internal Revenue Code provides an unlimited gift tax exclusion for payments of tuition made directly to an educational institution on behalf of an enrolled student. For individuals who anticipate paying for a child’s higher education needs via their established cash flow or existing savings, this exclusion makes the payment of college tuition costs rather academic. So long as the tuition bill is paid directly to the school, the grantor should not face any gift tax consequences. Additionally, using this unlimited exclusion circumvents the use of the annual gift exclusion amount each year to save for something which you could pay outright with no gift tax consequences.
2. 529 Savings Plan
A 529 savings plan is a special type of savings account operated by either a state or an educational institution that offers unique benefits including tax-free growth and the potential for a state income tax deduction on contributions. Additionally, as the donor, you retain complete control over funds in the account, meaning that you can change the beneficiary or withdraw the funds at any time. It is important to keep in mind, however, that if the earnings portion of the account is withdrawn for non-qualified expenses (items other than tuition, room and board, books, etc.), you will incur both income tax and a 10% excise penalty. (For related reading, see: 5 Secrets You Didn't Know About a 529 Plan.)
3. Custodial Accounts
Custodial accounts are easy to establish in that normally a simple account-opening form is all that is required. Funds deposited into the account can be used for anything that will “benefit the child,” a broad concept that is not limited to higher educational expenses like a 529 plan. Contributions to custodial accounts count as completed gifts, meaning they qualify for annual exclusion gifting. During the beneficiary’s years of minority, the custodian (often the parent or grandparent) retains control over the account and the distribution of funds.
Drawbacks to custodial accounts include:
- All of the income and capital gains generated by the account are taxable. Further compounding the problem is the possible imposition of the Kiddie Tax. The net unearned income of a child under the age of 19, or age 24 if a full-time student, is taxed at the parent’s/guardian’s marginal rate—the highest rate applied to their last dollar earned. (For related reading, see: A "Kiddie Tax" Overview for Parents.)
- The transfer of funds into a custodial account is considered irrevocable, as soon as the dollars enter the account they are legally considered to be the property of the minor and must be used for that minor’s benefit.
- Finally, once the beneficiary turns 18 or 21 (depending on the jurisdiction where the account was established), the former minor gains complete control over the funds held in the account. It is easy to imagine a situation in which an 18-year-old may not be ready to handle an account funded with enough money to cover four years of college tuition.
4. Trust for the Benefit of the Child
Trusts provide the ultimate flexibility for how funds can be used, who retains control over the funds, and who pays the taxes generated by investment gains. An individual can create a trust where a trustee is granted complete discretion over the use of the trust funds for the benefit of a child. Furthermore, the creator of the trust can decide when, if ever, assets in the trust will pass outright to the designated beneficiary and the trust can be structured such that the tax consequences of investment gains are borne by the creator of the trust, not the beneficiary. Additionally, a trust may help protect a beneficiary from his or her own improvidence, the judgments of future creditors, or the division of assets that could accompany future marital discord. (For related reading, see: 5 Common Mistakes When Creating a Trust Fund for Your Child.)
As trusts can be complex and costly to establish and maintain, they are best suited for families that intend to fund accounts with dollars well in excess of what will be needed to cover anticipated education costs, with the goal of providing a more enduring legacy for a child.
5. Roth IRA
Finally, using a Roth IRA as a vehicle to save to for higher education expenses makes sense if 1) you are already secure in your retirement planning and 2) you believe there is a strong possibility the child will receive some form of scholarship/aid to attend college. You can always withdraw an amount equal to your contributions from a Roth IRA without tax or penalty consequences. Earnings can also be withdrawn penalty-free if the funds are used to pay for qualified education expenses for you, your spouse, your children or your grandchildren.
The advantage here is that you are creating options in your financial plan. If you end up needing to use the funds for college, you can withdraw them without a significant income tax burden. Alternatively, if you do not need the funds (i.e. if the scholarship comes through), you have boosted your retirement savings. However, a word of caution: you should never jeopardize your own retirement to help pay for a child’s education—while one can borrow for college, one can’t borrow for retirement spending needs. (For related reading, see: Pay for a College Education With Retirement Funds.)
Each of these savings strategies presents its own challenges and opportunities. Which one will ultimately best suit your individual needs is a question best explored with your financial advisor.
(For more from this author, see: How Our Investing Habits Matter.)