By Danielle Harrison, CFP
Long gone are the days when most students could work summers and weekends to pay for their college tuition. Over the last several decades, the cost of college tuition has increased by five to eight percent per year, more than double the rate of inflation. If this trend continues, today’s parents of young children could be faced with a price tag of over a quarter-million dollars per child when the time comes—that is for a four-year, public, in-state education!
The hefty price tag of higher education can easily derail a family’s financial goals if they do not get a proper plan in place. While there are several strategies to keep the cost of higher education down, as well as the possibility of government aid to help alleviate some of this burden in the future, families must still decide their best options for funding the higher education of their children.
According to a survey completed by Sallie Mae, one of the largest private student loan lenders in the U.S., 70% of parents utilized their current income to pay for a portion of higher education expenses in 2020. Due to the high cost, however, the vast majority had to either supplement their current cash flow or come up with other sources entirely to pay for their children’s schooling. What are the best options for your family?
Section 529 Plans (Qualified Tuition Programs)
Although several states have had their own tuition plans dating back to the 1980s, Internal Revenue Code Section 529 was created almost two decades later, which allowed for the tax-deferred treatment of earnings in these plans and spurred the majority of states to implement savings initiatives of their own. There are two types of 529 plans—prepaid tuition plans and college savings plans.
Prepaid Tuition Plans
Prepaid tuition plans let one lock in the future tuition rate at an in-state public college at current prices and are often guaranteed by the state. There is also a group of several hundred private colleges that offer a national prepaid tuition plan for private and independent colleges known as the Independent 529 Plan. However, prepaid tuition plans are beginning to go by the wayside. Twenty-two states used to offer prepaid tuition plans, but that number has dwindled to only nine accepting new enrollees as of 2020.
The biggest advantage of prepaid tuition plans is the ability to lock in future tuition rates. With the steep increases in tuition year-over-year, this can be an extremely valuable feature. There is typically flexibility if your child decides to attend an out-of-state or private institution and you have the option of transferring the funds to another one of your children.
Prepaid plans function much like pensions. Individuals pay into the plan, the state or institution invests the funds and pays out a set amount for tuition once the child attends college. In theory, this can work well, but it presents several problems. Unlike a 529 college savings plan account (discussed below) where you have an individual account where your contributions and earnings are held, prepaid plans do not attribute the earnings to you as an individual. If your child ends up not using the funds or attending a school not covered under the prepaid plan, you can get your contributions back, but not the earnings. The impact of losing out on nearly two decades of compounding returns can be substantial and is a risk that should not be taken lightly.
Under a prepaid plan, you are also dependent on the state for funding. If the state is not able to generate a higher rate of return on the funds than the increasing tuition rates, they could close the plan or refund your investment causing you to again lose out on returns. For example, the State of Illinois has repeatedly had issues with its prepaid tuition plan that was at one point over half a billion dollars underfunded. This particular state plan is not guaranteed by the state of Illinois, so there is no obligation on the state's part to keep the plan afloat.
To reap the most benefit, you should start saving into a prepaid plan when your children are very young. The problem, however, is that so much can happen between the time you begin saving and when your child enters college. What if your child is better suited to attend a technical school? What if the state schools covered by the prepaid plan do not offer the degree program that your child wants to pursue? What if you move to another state and now your child feels obligated to attend college in the state where the plan was set up, when all of their friends are attending other schools closer by? It is hard enough to make the decision on the best school your child should attend when they are a high school junior or senior, let alone making that decision eighteen years prior to them attending.
Finally, most prepaid tuition plans only allow you to save for tuition and other mandatory fees. Room and board and other incidentals which can account for half the cost of college are not typically covered, so you will likely need another form of savings for these costs. Because prepaid tuition plans are offered by individual states, it is important to carefully do your research into the plans as each one is different.
College Savings Plans
The second and more common type of Section 529 plan is the college savings plan. These plans present many advantages over other options. They offer tax-deferred compounding and tax-free withdrawals (much like Roth IRAs or Roth 401(k)s) for qualified education expenses including tuition, room and board, books, and more. They offer the flexibility of being able to change the beneficiary to another family member, including yourself or even extended family like cousins; have no income limitations for contributors; and high aggregate contribution limits giving you the opportunity to amass the funds needed to cover the high costs of post-secondary education.
Like prepaid tuition plans, college savings plans are made available to savers by each participating state. Unlike prepaid plans that typically have a residency requirement, with college savings plans you may choose whatever state plan works best for your situation. You are also not locked into a particular state plan forever—you are able to change plans as often as once a year.
If desired, an adult, such as a parent or grandparent owns the account and has control of the funds which allows for less impact on a child’s potential financial aid. Several states offer income tax deductions on contributions allowing for additional tax savings on top of the already tax-advantaged status. College savings plans also allow for estate planning flexibility, including the five-year gifting feature which allows a contributor to gift up to five years of the annual gift tax exclusion in one year—a wonderful option for grandparents and relatives looking to fund a child’s education while decreasing the size of their estate.
The biggest concern that a family may have in utilizing a 529 college savings plan is what happens if their child does not attend college, does not use all the money, or gets a sizeable scholarship. At any time and for any reason, contributions made to a 529 college savings plan can be withdrawn with no penalties or taxes—the exception is that in some states where 529 contributions are tax-deductible, the state may require you to pay back any tax savings you realized at the time you contributed to the plan. The earnings on the funds taken out and not used for educational purposes are the only thing subject to income taxes and a 10% penalty. If your child were to get a scholarship, you are able to withdraw the scholarship amount with no penalty, you just have to pay income tax on the earnings.
529 college savings plans also have other uses. For one, they can help fund K-12 private education to the tune of up to $10,000 per year, per beneficiary. This is very valuable for those living in states with tax deductions for 529 contributions. Thanks to the SECURE Act, up to $10,000 per beneficiary can be used to pay down student loans. In addition to the cost of college, trade schools, and vocational schools, the SECURE Act also added the cost of apprenticeships to the list of qualified educational expenses.
College savings plans can have their pitfalls. For one, many plans have limited investment choices and, per federal rules, you are only allowed to change the investments within the plan up to twice a calendar year. This should not be an issue as long as you choose a state plan that offers low-cost, index funds. Certain plans have high fees or only offer expensive actively managed funds, which can eat into your investment return. Investing for college does not need to be complicated and there should not be many changes to the investments except adjusting the stock to bond allocation as the child gets closer to attending school, which only needs to be done every few years.
There are also potential taxes and penalties to consider. If you do withdraw earnings that are not used for qualified expenses at a qualified institution, the earnings are taxable plus a 10% penalty applies. The contributions withdrawn are not taxed or penalized.
Some states have “recapture” rules. If you take a state income tax deduction and subsequently transfer the funds to a better plan in a different state or make a non-qualified withdrawal, the state in which the income tax deduction was taken can reclaim those deductions. Before choosing or moving plans, it is important to read all of the fine print.
Coverdell Education Savings Account (ESAs)
Like 529 college saving plans, Coverdell accounts allow for tax-free growth and distributions if used for educational purposes and account owners have the ability to transfer the funds to another beneficiary if the current one does not use some or all of the funds within the account. Coverdell ESAs have more investment options than a typical 529 college savings plan and are often used in tandem with 529 savings plans to pay for K-12 private school expenses. Coverdell accounts have fewer limitations on what qualifies as permissible K-12 expenditures and do not face the $10,000 annual limit per beneficiary that 529 savings plans have.
Coverdell accounts are subject to more limitations than 529 college savings plans, making them less common. There are income limits in place for contributions based on a family's modified adjustable gross income (MAGI), so these vehicles cannot be used by high earners. In 2021, income phaseouts are between $190,000 and $220,000 for those married filing jointly and $95,000 to $110,000 for those filing single.
The account must be established by age 18 and all funds used by age 30 (unless the account is for an individual with special needs) or it will be subject to penalties, taxes, and fees. The biggest limitation is that a maximum of $2,000 in contributions can be made per year per beneficiary. With the high costs of college, $2,000 a year is very unlikely to meet the savings needs required.
UGMA and UTMA Accounts
For quite some time, UGMA and UTMA accounts were the primary vehicles used to save for higher education. The Uniform Gifts to Minor Act (UGMA) established a simple way for a minor to own securities without requiring the services of an attorney to prepare trust documents or the court appointment of a trustee. The Uniform Transfer to Minors Act (UTMA) is similar but also allows minors to own other types of property, such as real estate, fine art, patents and royalties, and for those transfers to occur through an inheritance. The accounts are held in the name of the child, but also name a custodian who is in charge of the account until the minor reaches the age of majority, age 18 or 21 in most states.
The main advantage of using UGMA and UTMA accounts is that the funds can be used for more than educational purposes. But, this advantage can also be viewed as a disadvantage. At the age of majority, the child will gain full access to the funds with no restrictions. The money saved for their college education or other desired goal could easily be spent on other items that may be deemed more desirable for an 18- or 21-year-old, say maybe a fast car or rounds of drinks for their friends at the bar. Once funds are transferred to the account, they belong to the child and cannot be transferred to another beneficiary. For financial aid purposes, UGMA and UTMA accounts are considered an asset of the child and will have a larger detrimental impact on funding than an account held in a parent's name, such as a 529 college savings account.
Another issue that is often overlooked with custodial accounts like these, is the potential “kiddie tax” implications. The kiddie tax is a tax on unearned income over a certain dollar amount that minors receive. It was put in place to discourage individuals from moving assets to their children and grandchildren who are presumably in a lower tax bracket as a way to decrease their tax liability. Under the SECURE Act of 2019, the kiddie tax is assessed at the parent’s marginal tax rate.
Investment accounts held in a parent’s name allow for easily accessible money with no stipulations or penalties if the funds saved for education are not needed. The downfall, however, is there are no special tax advantages like 529 or Coverdell accounts receive. Brokerage accounts held in a parent’s name are also counted negatively when it comes to financial aid, though not as negatively as if the funds were in the child’s name.
Using Retirement Accounts
According to the previously mentioned survey completed by Sallie Mae, in 2020, 14% of parents withdrew from their retirement savings (401(k)s, IRAs, etc.) to pay for college. Seven percent took out 401(k) loans.
For traditional IRAs, if the account holder is less than age 59 ½ there is typically a 10% penalty for withdrawals, but that penalty does not apply to withdrawals used for qualified higher education expenses such as tuition, fees, books, supplies, equipment, and room and board (if enrolled at least half time). Despite there being no penalty, ordinary income taxes apply to the full amount of any withdrawals. The withdrawals are considered income, increasing your adjusted gross income (AGI) which could inadvertently impact other benefits you may qualify for based on income status and negatively affect the FAFSA formula and your Expected Family Contribution (EFC) in future years.
For Roth IRAs, contributions can be withdrawn at any time and for any reason and are not taxed because you have already paid income taxes on that money. Earnings, however, are penalty-free if used for qualifying educational expenses, but are taxed as ordinary income if the account holder has not reached age 59 ½ and has not had a Roth IRA account open for at least 5 years–what is known as the 5-year rule.
If you are looking at taking funds from your current employer’s 401(k) or other employer-sponsored retirement plans, your options will depend on the plan and whether in-service withdrawals are allowed. If in-service withdrawals are allowed, and you are not yet age 59.5, you will face income taxes as well as a 10% penalty on the amount withdrawn. This is not a great option.
An advantage of saving funds within a retirement account to pay for higher education is that the money held in retirement accounts is not counted for the purpose of the FAFSA formula. Though, like traditional IRAs and 401(k)s, the disbursements from these accounts can affect your AGI and financial aid. Another advantage is that control of the funds remains with the account holder.
Because of contribution limitations, only a limited amount of money can be added to retirement accounts annually. There are further income limitations for IRA and Roth IRA contributions. Individuals who dip into their retirement savings can also be putting their future in jeopardy. Retirement accounts are meant to support you for many decades in retirement and depleting the funds for another purpose runs counter to that goal.
A 401(k) loan is another option to pay for educational costs if offered by your employer’s plan. This option presents many downsides, such as potentially not being able to contribute to your employer’s plan and take advantage of the employer match while paying back the loan. You can also be forced to repay a 401(k) loan with little notice and within a short amount of time if you were to suffer a job loss or your employer terminates the plan; failure to repay the loan quickly can result in significant penalties. Most plans only allow for one loan at a time and it must be paid back within five years. For a four-year degree, this payback period does not tend to be very beneficial.
Using Your Home
Many families’ largest asset is their home, as a home acts as a forced savings vehicle. As a result, it is no wonder why nearly 10% of families use the equity in their homes to fund their children’s higher education. Refinancing your home to a lower rate or extending the maturity of the loan can help free up cash flow to help pay for higher education. There are also other options including cash-out refinances, home equity loans, and home equity lines of credit.
The main advantage of using the equity in your home to pay for higher education costs is that the interest rate is typically lower than many other types of loans. Prior to 2017, the interest on home equity loans and lines of credit were deductible when used for educational purposes. Following tax law changes in 2017, from 2017 to 2025, the interest is only deductible if the funds are used to buy, build, or substantially improve your home. The biggest downfall of using your home equity to fund educational costs is that if you do not make the payments in a timely manner, you could lose your home.
Although not always the preferred method, the reality is that for many families, educational loans will be one piece of the funding puzzle. These can be in the form of student or parent loans, subsidized or unsubsidized, federal or private, with the best option being federally subsidized student loans.
Subsidized loans are available to students who demonstrate financial need. While the student is in school at least half-time, the Department of Education pays the interest on their loans. For unsubsidized loans, although students do not have to begin repaying their loans until after they complete their education or drop below half-time, interest begins to accrue on the balance of their loans while they are still in school.
Parental loans are unsubsidized and repayment begins after the loan proceeds are disbursed, while your child is still in college. There are deferment options, but interest continues to accrue.
For federal loans, both student and parent should typically be exhausted before seeking private loans. Federal loans tend to offer more options and flexibility, particularly when it comes to forms of repayment, than private loans which are made by a lender and subject to the lender’s terms and conditions. Students often need a parent to co-sign on private loans, which is not advised. Also, if something were to happen to the child, federal loans (both student and parent) can be discharged upon their death, whereas with many private loans this is not the case.
A downfall of any higher education loan is the fact that it is exceedingly hard to get rid of these debts. Although not entirely impossible, student loans (both federal and private) are rarely discharged even in the case of bankruptcy. The borrower must show that it causes “undue hardship on you or your independents” which is tough to do and very subjective.
Despite the many options available to fund higher education costs, for the vast majority of families I advise using the 529 College Savings Plan as their foundation. If you are looking to plan ahead for your children’s educational future, it makes sense to have a separate account designated for the goal. The tax savings coupled with the flexibility of the account makes it an easy decision. After establishing a solid savings strategy utilizing a 529 college savings plan, other solutions can be used to fill in any gaps.
About the author: Danielle Harrison, MBA, CFP®, CFT-I™
Danielle R. Harrison, is the founder and president of Harrison Financial Planning, a fee-only financial planning firm based in Columbia, Missouri, and equipped to work with clients across the country. Harrison Financial Planning provides comprehensive financial planning and investment management and is there to help guide clients through any financial decisions that arise. Harrison Financial Planning specializes in working with busy professionals and retirees who enjoy giving back through their profession, volunteerism, or charitable giving.
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