Saving for College

A Guide to Common College Savings Vehicles

One of the most challenging discussions we have with young families is helping them think about the intimidating costs of higher education.  Not only is college expensive today, but the cost seems to increase at a higher rate every year. In this piece we compare the most popular ways to save for college. We dissect the pros and cons so that you have all the information you need to make the best decision for your family when it comes to saving for college.

529 Plan

A 529 Plan is an investment vehicle that offers tax advantages to save for future education expenses. Advantages of 529 plans:

• Tax Advantages: More than two-thirds of states provide a state income tax deduction or tax credit based on contributions to the state’s 529 plan. You must save to the plan for the state that you are a resident in to receive the state tax deduction.  In addition to tax deductions, earnings accumulate in the 529 plan on a tax-deferred basis and are entirely tax-free when you take them for qualified higher education expenses. You can also use up to $10,000 per year for K-12 private or public education per beneficiary.

As you can see in the chart, tax deferred earnings can contribute significantly to growth. This illustration assumes a $100,000 initial investment, with subsequent annual investments of $5,500. Those investments grow at 8% per year. The investor is in the 35% combined Federal and state income tax bracket.                                                                                                                                                                                                                                                           

• Control: With few exceptions, the named beneficiary has no legal rights to the funds in a 529 account, so you can assure the money will be used for its intended purpose. This differs from custodial accounts under UGMA/UTMA rules, where the child takes control of the assets once he or she reaches legal age. A 529 account owner can withdraw funds at any time for any reason – but the earnings portion of non-qualified withdrawals will incur income tax and an additional 10% penalty tax.
• High Contribution Limits: 529 plans have high aggregate contribution limits, and no annual contribution limits unlike other types of savings plans. Depending on the state you live in, the maximum aggregate limit, or lifetime contribution limit, can range between $235,000 and $529,000. Contributions to a 529 plan are considered gifts and can be subject to gift taxes if they are over annual gift tax exclusions and the lifetime exemption.
• Financial Aid Advantages: If a 529 plan is owned by a parent it will be treated as an asset on the FAFSA (Free Application for Federal Student Aid). However, the 529 account will only be counted at a maximum of 5.64% of an expected family contribution. This is a huge benefit as a large 529 balance can have minimal impact on your ability for needs based financial aid. 
• Simplicity: A529 plan is a very hands-off way to save for education. To enroll, simply contact your financial advisor, or Google your state’s plan. Most plans allow you to ‘set it and forget it’ with automatic investments that link to your bank account or payroll deduction plans. Generally an investment company like Fidelity or Vanguard will be the custodian of your account, and we will help you choose the investments.
• Flexibility: The plans are flexible; you can change the name of the beneficiary to a different child or to pay for their college or higher education instead. This is helpful if one child doesn’t go to college or if you have leftover funds after the first finishes. Funds can also be used for graduate school education.

While there are many advantages of 529 accounts, there are also disadvantages.

• Penalties: The funds from 529 plans must be used for education. If they are used for anything other than K-12 Education or secondary education, you will owe income taxes on the investment gains, as well as a penalty of 10%. Qualified education expenses include tuition and fees, room and board and even textbooks. They may also include other expenses for attending college such as a computer and software used primarily for the classroom.
• Investment Choices: Each state offers their own plan with their own investment menus. You are limited to choose from their menu of their investments. Often the investments can carry significant fees and expenses. We are happy to help you review your options and find the best investments for your family.
• State Restrictions: To take advantage of any state tax deductions offered for contributions to a 529 plan, you must invest in the plan offered by the state that you are a resident of. Each state has their own plan, and their own requirements with their own set of investment options. You always have the option to use a plan from another state, but you will not receive the tax deduction benefits. Sometimes, you may find using another states plan is more advantageous.
• Fees: Each plan comes with its own set of fees. There can be set up fees, maintenance fees, account minimum fees, investment fees and transaction fees.

UTMA and UGMA ACCOUNTS

Another common savings vehicle is the Uniform Transfer to Minors Act or Uniform Gifts to Minors Act, or UTMA/UGMA. An UTMA/UGMA is an account that is owned by a minor child. Since children cannot own assets, the account is managed by a defined custodian until the child reaches the age of majority (18,19 or 21 depending on the state). The only difference between an UTMA and an UGMA is that an UTMA can hold physical assets such as real estate and art, while an UGMA cannot.

Here are some of the advantages of an UTMA/UGMA accounts

• Convenience: UTMA/UGMAs can be opened at your local bank, or at most brokerage institutions. The fees are usually reasonable and require very little leg work to open.
• Contribution Limits: There are no contribution limits for UTMA/UGMA accounts other than the annual $15,000 gift tax exclusion.
• Investments: You can choose how to invest the money. You can use stocks, bonds, ETFs, or mutual funds. Unlike 529s where your investment options are limited.
• Flexibility: You can use an UTMA/UGMA account for any purpose as long as it is for the benefit of the minor owner. There are no penalties when you take the funds out. This can be helpful if your child does not go to college.

Here are some of the disadvantages of UTMA/UGMA accounts

• Financial Aid: Assets in a UTMA/UGMA account are reported as students’ assets on the FAFSA. Student assets reduce eligibility for needs-based aid by 20% of the asset value, while at most 529’s reduce eligibility by 5.64%
• Control: Perhaps the biggest disadvantage of UTMA/UGMA accounts whether you use them for college or not is the lack of control. Once the minor reaches age of majority, the account is no longer controlled by the custodian, and the minor now can do anything they want with the assets.
• Taxation: An UTMA/UGMA account can be taxable. Earnings from an UTMA/UGMA account are considered unearned income. This includes interest, dividends, and capital gains. Here is how UTMA/UGMAs are taxed.
  • The first $1,100 is tax free
  • The next $1,100 is taxed at the child’s rate
  • Anything above $2,200 is taxed at the parent’s rate

              So, depending on how large the account grows to, they can become tax inefficient.

UTMA/UGMAs accounts are a less favored option if the goal is to fund college. UTMA/UGMAs are great accounts for helping your kids with non-educational expenses like buying their first car or home.

ROTH IRA

A Roth IRA is a type of individual retirement account that allows the owner to make after-tax contributions to the account. The funds grow tax free while invested, and then you can withdraw the funds tax free after age 59.5. A Roth IRA is most often in the name of the parent, however if your child has income earned in a given year, they are able to open a Roth IRA and contribute up to the amount they earned (still limited to the $6000 max).

While it is rare to open a Roth IRA with the intention of using the funds specifically for college, sometimes clients need an alternative source of funds. Here are some of the advantages of a Roth IRA Account for College Savings:

• Flexibility: A Roth IRA account for education expenses, but it doesn’t have to be. Clients can contribute to a Roth if they are below the income thresholds, and those funds can be used for retirement. If there is some uncertainty as to whether a child will attend college, a Roth offers the flexibility of being able to fund both through one vehicle.
• Qualified Distributions are Tax Free- The owner of a Roth account can take tax-free return of contributions at any time; you do not have to wait until you are 59.5. The earnings portion of a Roth account will be subject to penalties of 10% if you take the money out before age 59.5
• Investment options- With a ROTH IRA, you are not restricted on what you can invest in. You can invest in individual stocks, bonds, ETFs, and mutual funds.

There are also many disadvantages to using a Roth IRA for college.

• Contribution Limits: For 2022 you can contribute $6,000 or $7,000 if you’re age 50 or older. Roth IRAs also come with income limits for who can contribute to them. If you are married and file a joint tax return making over $214,000, you are ineligible to contribute to a ROTH.
• No Tax Deductions: Unlike a 529 account, there are no state tax deductions for contributions to a ROTH account.
• Withdrawals: Only the portion of Roth IRA’s that you contribute are not subject to any tax or penalties from withdrawals. If used to fund college expenses before the owner has reached 59.5, the earnings portion of the account are not subject to any penalties, but you will pay taxes.
• Financial Aid Implications:  While distributions from Roth IRA’s can be tax-free, they are also counted on the FAFSA as untaxed income. Having to report this on the FAFSA can reduce eligibility for needs-based aid.
• Reduction in Retirement Funding: If you choose to use your Roth IRA account to fund college expenses, you are taking away from a valuable tax-advantaged asset for retirement savings. It is important to work with your advisor to determine your family’s goals when it comes to retirement and education funding.

In general, Roth IRAs are best used as a backup option for college savings.

Conclusion

Whether you chose a 529 Plan, Roth IRA, or some other vehicle to save for education, it is important to save early and often. The power of compounding is significant. We recommend automating your savings, so that you can take advantage of dollar cost averaging, and a “set it and forget it” mentality. We will work with you to determine your family’s education and retirement goals, and how you can best save for them.

VISIT OUR WEBSITE AT COMPASSAWEALTHMANAGEMENT.com COMPASS WEALTH MANAGEMENT LLC • 10 Water St. Guilford, CT 06437 • (203) 453-7000 Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.