College Savings Strategies
Almost everyone I know is thinking about saving for college. Millenials are thinking about going to graduate school. Gen Xers are worried about their kids’ education. And Baby Boomers want to help their grandchildren.
With so many people thinking about it, a common question I get is how to save for college. Coverdell Education Savings Accounts (“ESAs”) have been around a long time, but they have relatively low contribution limits ($2,000 per year per beneficiary) and the ability to contribute phases out as income rises, so they are not the best option for most clients.
Prepaid tuition plans are another possibility. They allow you to prepay a college’s fees today, locking in current costs. Unfortunately, most students don’t know in advance where they will attend college, and many states (including California) do not offer them, so prepaid tuition plans aren’t widely used.
The best option is the 529 college savings plan. With a 529 college savings plan (from now on I’ll just call these “529 plans”), you set aside money today, it grows tax-free, and you can use it for qualified expenses including tuition, fees, and room and board. You never pay taxes on the interest and gains on your investment.
When deciding how to set up a 529 plan, one should consider:
- How much and when to contribute?
- What plan to use?
- What investments to use?
This post shares some thoughts on these questions. For a discussion specific to your situation, call Archer Row Advisory today at (818) 539-8808.
How much and when to contribute
When deciding how much to contribute, think about how much money you need to save for college and when you will incur those expenses. The cost of many private colleges (referred to as the “cost of attendance”), when you add up tuition, fees, and room and board, is about $70,000 per year today. That’s almost $300,000 per kid for four years of college!
If the students you are saving for are young, the cost is going to be more – potentially quite a lot more as college costs have been rising much faster than inflation for the past decade.
Assuming you won’t qualify for financial aid (see box, below), a good rule of thumb is to set aside the current cost of college. Although costs will go up as colleges raise their fees, your investments will grow, and the two should roughly offset.
And, as in most things with investments, now is the best time to contribute. That’s because the sooner you contribute the longer you have to grow the money, tax-free.
You will want to contribute as much as you can (within reason). The contribution limits follow the annual gift tax exemption, which is now $15,000 per person. So, a married couple can set aside $30,000 per year, per kid.
But if you have more money available, you can “super-fund” a 529 by contributing up to five years of contributions at once (that’s a maximum of $150,000 for a married couple, per kid). (If you super-fund, you have to wait five years to contribute again and you also file Form 709 United States Gift (and Generation-Skipping Transfer) Tax Return with your tax return.) You still might want to contribute more, but super-funding gets you off to a great start.
Here are some additional tips on how much and when to contribute:
- Don’t be afraid to over-contribute. If you have too much money in a 529 plan, you can change the beneficiary to use the money for a relative’s educational expenses. And, if you need to take money out of a 529 plan, a fee is assessed, but it is only 10% applied to the investment gains, which is not very punitive. In fact, considering you aren’t paying taxes on dividends, interest and capital gains earned, you might still end up better than if you had kept the money outside a 529 all along. (This is why Congress contemplated raising the penalty several years ago, to avoid using 529 plans as tax-deferred investment vehicles without any intent to save for college.)
- Look into state tax deductions. In most states, a contribution to certain 529 plans is tax deductible. That’s not the case in California, but it is in Washington, D.C., Arizona, New York, and Connecticut, among others. If you live in a state that doesn’t provide an income tax deduction, if other relatives (like a students’ grandparents) are in a state that has a deduction, you may want to consider coordinating your 529 strategy. If you do this, though, talk to a financial adviser to make sure you don’t adversely impact financial aid.
- Use a 529 for pre-college school expenses. Representative Paul Ryan injected a provision in President Trump’s tax reform to allow use of 529 plan monies of up to $10,000 per year for private school grades K-12. So, if you expect to have private school expenses before college, you can use a 529 for them.
What plan to use
There are a relatively limited number of 529 college savings plans to choose from. If you are looking to take advantage of tax deductibility of contributions, you have to use the plan for that state.
Otherwise, you can use any 529 plan.
Some tips:
- If deducting contributions, read the fine print. If you are looking to deduct your contributions, the account owner may have to be the person making the contribution. And, in some states (including, most notably, New York), changing the account owner is either complicated or not allowed.
- Use one plan per child. Although you can change beneficiaries relatively easily, since the beneficiary of the plan has to match the student at the institution, if you have one plan for many children who are all in college at the same time, you will have to change the beneficiary back-and-forth frequently, which can be a hassle.
- Consider the investment options before you open your account. Because 529 plans have a limited offering of investments, you need to consider the options available before opening the account or you may be unpleasantly surprised with your choices and you may have to pay fees that are too high.
What investments should I use
Once you have chosen a plan, you have to choose which investments to put the money in. There are limits on how you can invest the money because 529 plan sponsors usually only offer a fairly limited number of investments. And, you can’t move money between those investments very often (twice per calendar year).
Some tips:
- Keep costs down. Costs on 529 plans are higher than other mutual funds you may buy, so make sure to look at those costs and find investment options that have lower management fees.
- Reduce risk as beneficiaries near college. Saving for college is a long-term proposition. However, as you get closer to spending the money, you should reduce risk. As you review your portfolio each year, you should be looking at how your 529 plans are invested.
- Be wary of Target Date funds. Target date funds sound ideal – as you near the target date, the asset allocation becomes more conservative and this should protect you against market shocks right when you need the money. Unfortunately, in the 2007-2009 financial crisis, target date funds that were close to target and should have been relatively safe lost a lot of money (Fidelity’s 2010 target date funds lost 33% and others fared even worse). So, monitor your fund’s risk, even if you invest in a target date fund.
Because of the various complicating factors (how much to contribute, tax deductibility, investment options), you may want to speak with a financial adviser to help figure out your approach. If you have questions, call Archer Row Advisory today at (818) 539-8808 or click here to leave a message.
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