College Saving Plans: A Comparative Analysis
Planning for your child’s education can be a daunting task, especially when considering the rising costs of tuition. One of the most popular ways to save for college is through a 529 plan, but there are other education investment accounts that can also be beneficial. In this blog post, we’ll explore 4 different types of college saving investment accounts: 529 Plans, Uniform Gifts to Minors Act (UGMA), ROTH IRAs accounts, and Life Insurance. Below is a summary of some of the advantages and disadvantages of each option.
529 Plans: Educational 529 savings plans are state-sponsored investment accounts that offer tax-free growth and tax-free withdrawals for qualified education expenses. They are a great way to save for college and can be used at any accredited college or university in the country. The program has also been expanded to cover K-12 education and apprenticeship programs. 529s can also be used to pay off student loans and fund a ROTH IRA.
- Federal Tax Breaks: Funds invested in 529 plans grow tax-deferred like a 401(k) plan. You don’t pay taxes on 529 earnings used for qualified education or apprenticeship expenses.
- State Tax Breaks: every state has different rules for 529 plans. Some states may offer tax benefits such as tax credits or a tax deduction for contributions to 529 plans. However, others, tax 529 plan distributions.
- High Contribution Limits: Unlike other savings plans, while 529 plans have no annual contribution limitsfive-year aggregate contribution that in 2023 can greater than $550,000. However, all States have their own limits. In 2023, if you gift more than the annual exclusion of $17,000, or $34,000 for a married couple to the same beneficiary requires completing an IRS form when filing your taxes and could trigger gift taxes. Consult your tax advisor if you have any concerns.
- Flexibility: Funds can be used for a wide range of educational expenses.
- Minimal Impact on FAFSA: The Free Application for Federal Student Aid (FAFSA) is used to determine your eligibility for financial aid. Luckily, 529s owned by the dependent student or parent are considered to be parental assets, which minimally impacts your award. The first $20,000 of a 529 plan will fall under the Asset Protection Allowance. The remainder will reduce your beneficiary’s aid by 5.64%. So, you’ll lose just $564 per $10,000 above this threshold, which is negligible compared to the tax-deferred investment gains.
- Transfer Unused Savings: Unused college savings can be transferred to a beneficiary’s retirement savings without taxes or penalties.
- Limited Use of Funds: The benefit of the plan is limited only to qualified educational expenses.
- Penalties: If you don’t use the funds for qualified expenses, you’ll have to pay ordinary taxes on any investment gains and a 10% IRS penalty tax
- Contributions: Contributions are not tax-deductible on federal tax returns
UGMA/UTMA Accounts: The Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) accounts allow gift transfers to minors outside just cash and securities and can include real estate, inheritances, and other physical property. These custodial accounts allow you to save money for your child’s education while also giving them control over the account once they reach the age of majority.
- Flexibility: UGMA accounts provide a great deal of flexibility because they can be used for any purpose.
- Simplicity: UGMA accounts are simple, easy to understand, and very easy to set up. Trusts can be set up without a lawyer and ensure the beneficiary can’t access funds prematurely.
- Limited Tax-Free Growth Options: Unlike 529 plans, UGMA and UTMA don’t offer substantial tax advantages. In 2023, the IRS “Kiddie Tax” rules state that the first $$1,250 of unearned income falls under the standard tax-free deduction, the next $1,250 of earnings is taxed at the child’s low or minimal tax rate, while unearned income above $2,500 is taxed at the parent’s tax rate. UGMA account-generated earnings are not tax-sheltered.
- May Decrease Financial Aid Eligibility: 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.
Roth IRAs: While not specifically designed for education savings, Roth IRAs can be a great way to save for college. Roth IRAs are very versatile accounts since they offer tax-free growth. This is provided that you’ve had the account for at least 5 years.
- Tax-Free Growth and Withdrawals: Contributions to a Roth IRA are made on an after-tax basis. You can withdraw your contributions at any time and any potential earnings can be withdrawn tax-free in retirement. Once you turn 59.5, then you can withdraw Roth IRA funds without taxes or the 10% penalty! This can make it a powerful retirement and education planning tool, especially if you’re an older parent or grandparent.
- No Restrictions for Specific Expenses: Unlike Coverdell ESAs, 529 Plans, or other accounts; there are no restrictions for Roth IRA distributions on specific educational expenses. If you’re younger than 59.5, you can distribute $10,000 penalty-free once in your lifetime to pay for higher education expenses.
- No Required Minimum Distributions: Roth IRAs do not have required minimum distributions (RMDs) for the original owner.
- Income Restrictions: You cannot contribute to a Roth if your income exceeds a certain limit.
- Contribution Limits: The 2023 annual contribution limit is $6,500 if you’re younger than 50, and $7,500 per year if you’re 50 or older.
- Financial Aid Impact: While contributions can be withdrawn at any time without penalty, and earnings can be withdrawn tax-free for qualified education expenses, withdrawals are considered income for Financial Aid purpose, reducing financial aid packages.
Life Insurance: Life insurance is often considered as a means of providing financial security for your loved ones in the event of your death. However, some types of life insurance policies also offer a cash value component that can be used as a savings tool, including for college expenses.
- Tax-Free Growth and Withdrawals: The cash value of a life insurance policy grows tax-free. If the policyholder needs access to their insurance policy to pay college fees, they can borrow from their cash value balance. The proceeds are not taxable, making fee payment to college tax-free.
- Financial Aid Benefits: Cash-value life insurance is not counted as an available asset in financial aid calculations. If the policy is constructed properly, a family could conceivably shelter tens of thousands of dollars into a policy without it hurting a student’s financial aid prospects.
- High fees: Life insurance policies may have high fees and commissions, which can eat into the cash value of the policy over time.
- Policy Termination: Cancelling a policy during the surrender period will result in fees and likely tax consequences.
- Impact on Cash Flow and Retirement Savings: Using a life insurance policy to pay for college can affect the cash flow and retirement savings of the policy holder.
- Reduced Death Benefit: If you withdraw funds from the cash value, it reduces the death benefit of the policy by them amount withdrawn.
- Financial Aid Impact: While the portion of the cash value made up of premiums may be withdrawn tax-free and without penalty, money withdrawn from the cash-value part of the policy is treated as a form of income and does count against financial aid the following year.
Saving for college is a significant financial goal for many families. However, as I state to my clients, you can borrow for college, but you can’t borrow for retirement. Choosing the right college saving plan requires careful consideration of your financial goals, risk tolerance, and desired flexibility. Financial Life Planning can help you create a customized plan that weighs your unique situation and goals. We will assess your unique situation, explain the pros and cons of each plan, and guide you towards the most suitable option. With our guidance, you can make informed decisions and secure a brighter future for your loved ones. Remember, the earlier you start planning and saving, the better prepared you’ll be to handle the costs of higher education.
Use the “Click for A Free Consultation” Button to see how Financial Life Planning can help you navigate the complex world of college planning.
Edward C. Goldstein, CFP®, MBA, President
CERTIFIED FINANCIAL PLANNER ™ Practitioner
Financial Life Planning, LLC
10,000 Lincoln Dr. East, Suite 201
Marlton, NJ 08053