Saving for College

According to the Office of Federal Student Aid, student loan debt exceeded $1.51 trillion as of December 2019. A recently conducted Harris Poll found that the average student debt for the graduating class of 2016 was $37,000. During the next school year, 2016-2017, only 13% of families used a 529 plan for tuition funding. Student debt is an incredible door-opening resource for many students and families, however, given the opportunity and time horizon, student loans are not the most efficient mechanism for funding college. No matter where you want your child to graduate from, the goal is to use the least amount of dollars possible to achieve the desired education. So how do you achieve the goal of education funding efficiently? Start early, pick an appropriate vehicle, and be consistent.

Sequential Savings

  1. Initial Emergency Fund and Debt Payoff Planning
  2. Fully Funded Emergency Fund
  3. Health Savings Account (HSA)
  4. Employer Retirement Plans – 401(k)s and 403(b)s
  5. Individual Retirement Accounts (IRAs) & 529 College Savings Plans
  6. Taxable Brokerage Accounts

If starting early is such a key part to achieving your college savings goal, why is it number five on the list? After all, retirement will most likely take place after your children enter college so why prioritize the 401(k) and IRA over the 529 plan? Let’s start from the beginning.

The emergency fund provides the buffer needed to make sure the entire plan does not implode. Next, the HSA maximum annual contribution for 2020 is only $3,550 for self-only coverage and $7,100 for family coverage. Not only that but the HSA provides an income and payroll tax deduction upon contribution, income in the account is never taxed, and distributions for qualified medical expenses are tax free. The HSA is also very flexible allowing you to save your medical receipts so you can leave the money in the HSA and reimburse yourself later. Perhaps you decide to pay your medical bills out of pocket and reimburse yourself from your HSA when your child enrolls in college after years of tax-free growth inside the HSA.

Fourth on the list is the 401(k) or any other workplace retirement plan. The goal here is to take full advantage of any employer benefits such as matching contributions. The 2020 401(k) contribution limit is $19,500 but it is not necessary to fully fund the account at this stage. Once you maximize any “free-money” from your employer, look at step five before going back to max out your 401(k) or 403(b).

Here we are, step five. The Individual Retirement Accounts (IRAs) and the 529 plans. These three accounts (traditional IRA, ROTH IRA, and 529 savings plan) are all listed together because they share very similar attributes.

529 Plans

There are two types of 529 plans that were added by Congress in 1996 to IRC Section 529. These plans are often also called qualified tuition plans (QTPs). The first type of QTP is prepaid tuition plans. These plans are usually run by individual educational institutions and allow participants to purchase “certificates” today that can be redeemed for tuition in the future. These plans put the investment risk on the institution or plan sponsor because tuition is “guaranteed” at a future date regardless of the inflation of tuition or the investment performance. These plans are not nearly as popular because they limit the choice of school.

The second type of QTP or 529 plan is what you are likely more familiar with, the savings plan. The savings plan is nothing more than a tax-advantaged investment account sponsored by the state and governed under IRC Sec. 529. Similar to a ROTH IRA, these plans do not offer a federal tax deduction when a contribution is made, but all distributions used for qualified higher education expenses are tax free.

Contributions to 529 Savings Plans

Two of the primary differences between ROTH IRAs and 529 savings plans relate to limitations on contributions. The 2020 maximum ROTH IRA contribution is $6,000 per person and married individuals with more than $206,000 in Adjusted Gross Income (AGI) on their 2020 tax return cannot make a direct ROTH IRA contribution at all. On the other hand, 529 savings plans do not limit contributions to an annual cap or have an income limitation. So, if Jim wants to fund a 529 savings plan with $75,000 for little Jimmy, he can do so no matter how much money he makes.

Jim’s desire to fund Jimmy’s 529 plan with a lump sum $75,000 contribution is great but he also needs to be aware that 529 contributions are considered gifts to his son. The federal estate and gift tax system allows any individual to gift up to $15,000 per person to anyone during a year without any gift tax consequences. This is called the annual gift exclusion amount. 529 plans have a special feature that allows five years of annual gift exclusions to be used in one year. To utilize this provision, Jim would contribute $75,000 ($15,000 x 5 years) to a 529 plan for Jimmy in 2020 and file a gift tax return Form 709 checking the box at the top of Schedule A to elect to use five years’ worth of annual gift exclusions to Jimmy all in 2020.

Investments & Growth

The largest drawback to 529 plans is the lack of options and flexibility. 529 savings plans are run by the state. Each state and the District of Columbia has a 529 plan and most accept non-residents in their plans. However, investment options are limited, and investment decisions changes can only be made twice a year. In addition, these plans typically have higher fees and expense ratios than a self-managed IRA. Websites like collegesavings.org and savingforcollege.com have tools to compare each state’s available 529 plans as not all are created equal. This 529 Plan Evaluation Form is another helpful resource in contrasting various state’s plans.

Distributions

Distributions from 529 savings plans that are used for qualified higher education expenses are tax and penalty free regardless of the level of growth in the account. Qualified higher education expenses include tuition, fees, books, supplies, equipment (including a computer and computer software needed), and room and board subject to certain limits. In addition, up to a cumulative lifetime amount of $10,000 may be used to pay principal or interest on existing student loans of the 529 plan beneficiary or the beneficiary’s sibling. The definition of qualified higher education expenses also includes up to $10,000 per year of elementary or secondary school tuition per student.

The investment growth on withdrawals not used for qualified higher education expenses is subject to income tax and a 10% penalty. Distributions are considered to be taken proportionally from earnings and previous contributions so unfortunately the flexibility awarded to ROTH IRAs to take out previous contributions FIRST does not apply to 529 plans.

Is the 529 Plan the Right Vehicle?

The 529 savings plan is by far the most popular college savings vehicle. The primary benefits of these plans are the same benefits available to ROTH IRAs with no contribution cap or income limit. However, 529 plans have much narrower allowable use parameters than IRAs. For instance, distributions from ROTH IRAs, up to the cumulative amount of previous contributions, can be taken at any time tax and penalty free. Also, once an IRA or 401(k) owner reaches the age of 59½ all distributions are penalty free.  IRAs also provide other penalty free distribution exceptions before the age of 59½ for qualified higher education expenses, large medical expenses, and first-time homebuyers. Health Savings Accounts allow the owner to save medical receipts and leave the dollars invested in the HSA to compound tax free until desired reimbursement by the owner at a future date.

529 plans do not carry as much flexibility. Distributions from 529 plans must be used for qualified higher education expenses in the year of the qualified expense. If the beneficiary of the account decides not to go to college or receives substantial scholarships the account owner has two choices: 1) distribute the account and pay income tax and a 10% penalty on the growth or 2) change the account beneficiary to someone who will use the funds on qualified higher education expenses.

Takeaway

529 plans are a great tool and are widely accessible due to the lack of any income or contribution limitation. The three steps to efficiently saving for college (or any goal for that matter) was start early, select an appropriate vehicle, and be consistent. Starting early and having consistency are far and away the most important steps. However, choosing the right vehicle can boost your savings and add flexibility. The 529 plan is great but if you have not taken full advantage of the $6,000 IRA maximum contribution amount available to both spouses, consider utilizing ROTH IRAs over 529 plans due to lower cost investing and a wider variety of penalty free acceptable uses. If you are looking to set aside more than $12,000 a year toward college savings or cannot fund a ROTH IRA, use the previously mentioned resources to locate the best 529 plan for you and most importantly, be consistent!