Pay for College
Comparing the impact of loans with the savings potential of CollegeBound 529 can help your clients find options that best suit their needs.
One of the biggest questions parents have about 529 plans is how they affect need-based financial aid.
Families have a lot of questions about the best way to save for college when their children are young. And when high school graduation arrives, so does a whole new list of questions about the best way to use those savings.
When planning for college, the option of student loans often comes up, especially if anyone involved has a "pull yourself up by your own bootstraps" mentality. But before signing on the dotted line, it's important to look at the impact student loans can have on a family's financial future.
529 savings can be used for a variety of education-related expenses at eligible (accredited) two- and four-year colleges and universities, US vocational-technical schools, and eligible foreign institutions, including:
- supplies and equipment
- room and board.
Your clients likely have several questions on the best way to save for education. And when the time to spend that money arrives, so do additional questions on the best way to spend their savings. Common questions are:
- How do I withdraw money to pay for my child's education? First your client must decide if the funds will be transferred to them or directly to the school. They will then need to review their qualified and non-qualified expenses.
- What is the best distribution strategy to withdraw from multiple accounts? The answer to this can depend upon which account has the highest appreciation, as well as financial aid criteria.
- What do I do with a 529 plan in the event my child earns a scholarship? If the child received a scholarship, your client can withdraw up to the total amount of the tax-free scholarship from his or her 529 account without incurring the 10% penalty — but will still have to pay income taxes on that amount. To put leftover funds to use without incurring a non-qualified withdrawal penalty, your client can simply change the beneficiary.
Every year, students who seek federal, need-based financial aid must fill out the Free Application for Federal Student Aid (FAFSA). It asks parents and students to disclose two things:
- Assets which include such things as:
- Money saved in cash, savings and checkings accounts.
- Businesses and investment properties.
- Other investments, such as UGMA and UTMA accounts, stocks, bonds, CDs, etc.
- Income, basically the same information your client reports on their income tax return.
All that information is plugged into a formula that calculates what the government calls the Expected Family Contribution (EFC), which tells colleges how much money the family has that can be used to contribute to college expenses.
- The EFC formula doesn't treat all assets and income the same. For example, it includes up to 20% of a student's assets and 50% of a student's income. For parents, the EFC calculation counts only 5.64% of assets but up to 47% of income.
- For grandparents and anyone else who gives money toward the student's college expenses, nothing is counted as assets. But, once the student spends that money on qualified expenses, the EFC calculation will count half of that as income for the year in which it's spent. That means the following year, when the students fills out the FAFSA, they'll have to report that money as income.
That's a problem most of us wish we had… a 529 college savings plan with too much money in it. But the student may receive a scholarship or decide against something they originally planned on. Then your client basically has five options:
- Keep the account as is for potential future educational needs of the beneficiary.
A 529 plan is flexible — it can be used to pay qualified educational expenses at any eligible post-secondary institution.
- Transfer the account to a different beneficiary.
The account holder can name another qualifying family member, including themself, as a beneficiary without triggering tax consequences.
- Leave an education legacy.
Because most 529 plans don't impose a time limit for using the money, your client and his successors can let the account continue to grow, potentially for grandchildren and even great-grandchildren.
- Take penalty-free withdrawals.
If the beneficiary earns a scholarship or appointment to a US military academy, the owner can withdraw up to the amount of the scholarship. While there's no penalty, earnings in the account are taxable.
- Spend the money on non-qualified expenses.
The after-tax contributions your client made to the 529 can be withdrawn without tax or penalty. Only the earnings on the contributions will be taxed as income, and are subject to a 10% penalty.
This is an important question to consider as you help parents incorporate paying for college into their overall financial plan.
There are three drawbacks with funding a single 529 for two or more children:
- 529 plans can be used only for qualified higher-education expenses of the named beneficiary, and only one beneficiary at a time.
- Investment allocation in age-based 529 portfolios are based on the age of the beneficiary, moving from aggressive to more conservative as college gets closer.
- Your client may not be able to take full advantage of tax breaks that 529 accounts offer, including individual gift tax exclusions.
One account for two children may make sense if, for example, there's a significant age difference. The owner could change the beneficiary when the older child has completed college and, of course, tweak the 529 investment allocation for the younger child.
Now, let's consider the strategy of opening a 529 account for each child. It remedies the drawbacks of having only one account for multiple kids because:
- All funds for qualified expenses are distributed tax-free1 for each beneficiary
- The most appropriate time-based investment allocation can be chosen for each child
- Your clients could potentially minimize tax breaks
- It's easier to track progress for each child
As a result of the Tax Cuts and Jobs Act, 529 savings plans aren't just for college expenses anymore.
Families with children in grades K-12 can now take federal tax-free withdrawals1 of up to $10,000 per year to pay for public, private, religious elementary or secondary school tuition. However, whether K-12 tuition will qualify for state tax benefits is still being determined on a state-by-state basis.
The cost of college is rising quickly, and your clients need their money to grow in order to keep up. Fortunately, there are several types of college savings solutions available, each with its own unique set of rules, features and potential benefits — understanding the basics is an important first step in the selection process.
- 529 plans: Operated by a state or educational institution, 529 plans can make it easy to save for education for a designated beneficiary. There are two types of 529 plans: pre-paid tuition plans, which lock in costs and have residency and other restrictions, and savings plans, which don't lock in costs but are much more flexible. While certain withdrawals are subject to federal, state and local taxes, 529 savings plans are tax-advantaged savings plans that have high contribution limits and allow earnings to grow tax-free when used for education expenses1. Many states also offer additional tax incentives.
- Coverdell Education Savings Accounts (CESA): These accounts are used to pay the education expenses of a designated beneficiary. They offer tax-free growth and tax-free withdrawals1 when the funds are used for qualified education expenses. Withdrawals can be used for qualified elementary and secondary education expenses, as well as for college. However, the maximum annual contribution is low at only $2,000 per beneficiary, and they are only available to families with income below a certain level.
- Custodial accounts (UGMA/UTMA): Custodial accounts are used by parents or grandparents to invest in a child's education, while taking advantage of the child's generally lower tax rate. These accounts also have no maximum investment limit. Because minors can't directly own an investment or bank account, an adult custodian must manage and use the funds for the benefit of the minor child, as prescribed under the state's Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA).
- Taxable accounts (savings accounts): These accounts are set up and owned by individuals with after-tax dollars to save for college or other goals. All earned income is taxable annually at the account owner's federal and state income tax rate and dividends and capital gains are taxed at a lower rate.
When planning for college, the option of student loans often comes up, especially if anyone involved has a "pull yourself up by your own bootstraps" mentality. But before signing the dotted line, it's important to look at the impact that student loans can have on a family's financial future.
By planning and investing for education, instead of financing with student loans, your clients have the ability to achieve a debt-free education.