Almost all parents, at one point or another, think about the best schools for their children and those thoughts inevitably turn towards the costs of that education. These nine points explore some best practices, and pitfalls to avoid, in planning for the costs of college.
1. It is never too early to start planning for college
The most significant opportunity a parent has is time. It is essential to understand the projected costs and the different options available. Many online tools can help project college costs and assist in creating a budget. There are also multiple ways to save for college including a standard savings account, an investment account, or the better known 529 plan. A 529 plan allows an individual to create an account and designate a beneficiary. The account owner is also allowed to change the beneficiary of that account at any time. The earlier a budget is made the more time there is to contribute, earn, and reach your goals.
2. It is never too late to start planning for college
Remember that even if your children are older, any planning is better than no planning. The IRS views contributions made to a 529 plan as a gift to the beneficiary. Current IRS gifting rules allow $16,000 from one individual to another without using part of one's lifetime gift and estate tax exemption. However, the IRS allows a unique feature for 529 plans generally referred to as super funding. This feature enables individuals to fund a 529 plan in one year for a single beneficiary up to $80,000 without using their gift and estate tax exemption ($160,000 in the case of a married couple to a single beneficiary).This feature can help accelerate a plan's funding. Be mindful of the timeframe for needing the funds, though, as some 529 plans are tied to the stock market's performance (see point 5 below).
3. Understand the 529 plan you are creating and its features
There are two types of 529 plans:
- The first plan type is a prepaid tuition plan. This allows the account holder to purchase "units" or "credits" at participating colleges and universities (there is a Private College Plan and a State-Sponsored Plan). These can then be used towards future tuition and mandatory fees.
- The second plan type is a college saving plan. This plan creates an investment account where contributions can grow tax-free, provided distributions from the plan are used towards "qualified education expenses" of the beneficiary. A list of qualified expenses can be found on the IRS website. Each type of plan has positive and negative attributes (see points 4 and 5 below).
4. The pros and cons of a prepaid college tuition plan
The major benefit of both the state and private prepaid tuition plans are that the units or credits are being purchased at today's prices. You are paying for the tuition now and hedging against the rising costs of tuition.
There are, however, a few downsides to this type of plan:
- The state-sponsored plan only includes the state's public institutions and, currently, only nine states participate (refer to your State or the Private College websites to view participating institutions)
- The account owner or beneficiary of a state-sponsored plan is generally required to be a resident of the state
- Both state-sponsored and private prepaid plans are not FDIC insured
- The plans cannot be used for costs outside of tuition and mandatory fees
- The ultimate benefit is limited if the beneficiary does not attend school at a participating institution as the contributions are held in trust and have limited earning potential
5. The pros and cons of a 529 college savings plan
College savings plans are offered by all 50 states and the District of Columbia.
The major advantages of this type of plan include:
- Neither the owner nor beneficiary needs to be a resident of a particular state
- College savings plans can cover more expenses than just tuition and mandatory fees
- These plans can be FDIC insured
- Contributions can result in a state tax deduction if you live in a state that allows for it and the plan was created in your state of residency resulting in an immediate benefit
However, there are also some disadvantages:
- The investment options may be limited
- The investments may go up or down like any other investment account
- The earnings are subject to taxation and a 10% penalty if the funds are not used for "qualified education expenses"
- There are varying fees depending on the state and whether your plan is actively vs. passively managed
6. Make sure to monitor and adjust your plan as needed
Continuing to fund your plan is key, but equally important is monitoring. If you purchased a prepaid plan, keep track of the universities that participate and whether your child has an interest in those institutions. If you started a college savings plan, keep track of the performance and the fees. You are not restricted to creating a college savings plan in your resident state (you generally cannot claim a tax deduction if you contribute to another states' 529 plan). Different states have different fees and some states have matching contributions for lower-income families. There are also different investing strategies such as age-based plans, static plans, passive plans, or actively managed plans. Each has different features and fees.
7. You and your spouse have a 529 plan for your children, but are separating/divorcing
This topic can often be overlooked. If you are separating or divorcing, make sure to discuss the plan you have established including what would happen if the ownership should change, and how future funding and distributions will occur.
Certain plans permit separated or divorced couples to continue joint ownership and joint contributions. There are other plans where splitting the account into two separate accounts or transferring the plan to one parent are the only options. If you must split or transfer, it’s important to name a successor owner in the event something happens to the account owner. If one parent becomes the sole owner, the spouse can request "interested party statements" to monitor the accounts. Please note where one parent is the sole owner they have ultimate control of the assets and the ability to request withdrawals without the ex-spouse's consent. You should also discuss how much to fund each year by each person to avoid overfunding or underfunding the plan.
8. Your child has entered college, and there is not enough or too much in the 529 plan account
If your child has started college and the 529 plan doesn't entirely cover the costs, there are other options to consider. First, you can still contribute when the beneficiary is in college. Funds deposited during freshman year still have three years to grow. Additionally, there are grants/scholarships or student loans that can offset the remaining balance. If student loans or personal funds are required, there are federal and state tax credits available. These tax credits do not allow you to use untaxed monies, so you cannot claim the credits using 529 plan funds. If your 529 plan is overfunded, there are also options. The account can be used for graduate school. If graduate school is not in the cards, don't worry, clothes are not the only hand-me-down item. The account owner may change the beneficiary or roll over the account to another child as well as change the beneficiary to themselves and use the funds for continuing education classes. If no other options work, you can simply withdraw the funds and pay the tax and penalty on the earnings.
9. You aren't the only family member who can help plan for college
As the old adage says, it takes a village to raise a child. Grandparents and other relatives can contribute to your existing 529 plan and grandparents can even create their own 529 plan or custodial account for the beneficiary. Create a dialogue with your family to aid in the planning. There are other options outside a 529 plan as well. If a grandparent or another relative is trying to remove income or assets from their taxable estate, they might consider paying for the tuition. The IRS does not consider the amount a gift, provided the individual pays the tuition directly to the college. This feature can be very useful in estate planning.
What does CohnReznick Think?The first step in the process is to start the conversation. Sit down and do your research. Come up with a game plan and ask questions where you need help. You aren't alone in going through this process. Other parents have been here before, and they may have insights you will find helpful. Ultimately, your plan is unique to you, your budget, and your situation.
Subject matter expertise
CPA, Managing Partner - Private Client Services
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