College Savings Choices

August 27, 2014

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As summer fades into fall, it’s back to school time for many kids across the nation. Amidst busy preparations, saving for college sometimes gets lost. However, one of the largest out of pocket expenses for families is college tuition. The average cost of sending a child to a 4-year school can be anywhere from $23,000 to $45,000 per year.

Unfortunately, while the cost of living as measured by the Consumer Price Index (CPI) has risen by 3.66% annually since 1978, college tuition costs have been rising much faster! Since the data was first recorded in 1978, college tuition and fees have risen by a total amount of 1,225%! Figure 1 below shows the incredible inflation in college tuition relative to medical care, shelter, food and CPI. Not only is it expensive to send your child to college, costs continue to rise at an incredibly high rate.

Figure 1: College Tuition Inflation

Source: Bloomberg

Parents pay for college expenses in a number of ways including their own income and savings as well as the student’s income and savings (see figure 2). These two categories make up 42% of the total. Recent data on college debt is alarming and furthers the argument for parents to plan for future expenses rather than relying heavily on student loans. A recent New York Times article estimated student loan debt has exceeded $1 trillion in total at a time when college graduates are having a hard time finding full-time work. While other consumer debt categories have seen a decline in the past 10 years, student loan debt has kept rising along with delinquencies. The percentage of loans delinquent 90 days or more has risen to more than 12% of the total.

Figure 2: Paying For College

Source: Sallie Mae

Clearly, planning ahead for college is an important part of a family's financial plan. There are a number of strategies, vehicles, and programs to save for education. Below are the most widely used college savings options:

  • 529 Savings Plans
  • Prepaid Tuition Plans
  • Coverdell Education Savings Accounts
  • UGMA/UTMA Custodial Accounts
  • Saving in the Parents' Names

529 Savings Plans

Section 529 plans are educational savings plans administered by a state designed to encourage parents to save for their future educational expenses. It's named after section 529 of the internal revenue code created in 1996. Every state offers a 529 savings plan. Assets in these accounts are not guaranteed like a prepaid tuition plan and are subject to financial market risk. Most 529 plans offer a number of different investment options such as cash, stocks or bonds, but investment options can be limited in number. Many also offer the ability to invest in a portfolio that has an adaptive asset allocation strategy that typically reduces risk as the child gets closer to college. The money is controlled by the account owner, which is typically a parent or guardian. Anyone can contribute to a 529 plan on behalf of a beneficiary; parents, grandparents, friends and even Great Uncle Stu! 

Contribution limits are high and vary by state, but on average the cumulative limit is $235,000. Earnings in the accounts grow tax-deferred and withdrawals are tax-free if used for qualified educational expenses such as tuition, room, board, books, supplies etc. Contributions may be deductible on your state income tax. If a 529 plan is closed and money taken out for non-educational expenses, you will have to pay federal income taxes on the earnings, plus possibly a 10% tax penalty. Plans are portable tax-free between family members.

Advantages

  • Tax-deferred growth and tax-free withdrawals.
  • State income tax deductions.
  • Great way for Grandparents to contribute to their grandchild's education.
  • Portability of the beneficiary between family members.
  • Low impact on financial aid eligibility.
  • High contribution limits.
  • No date by which the funds must be used.
  • Estate planning tool.

Disadvantages

  • Earnings may be subject to taxation and penalties if not used for educational expenses.
  • Limited investment options.
  • Depending on the investment options selected, the account can be subject to financial market risk.
  • Expenses can be high on some state's plans.

Bottom Line

529 plans are a great way to save for future college expenses. You should understand the varying asset allocation choices and invest according to the risk tolerance and time horizon of the child. Using a 529 plan in tandem with savings in the parents' names is a good strategy.

Prepaid Tuition Plans

Prepaid tuition plans offer investors the ability to purchase tuition for a student at current rates, even if he or she will not go to school for some years. These plans are less popular than 529 college savings plans and are only offered by 11 states, including Florida. A child must participate in the plan for three years before being eligible to use the funds. The plans are guaranteed to increase in value at the same rate as tuition, making them an interesting option to protect against tuition inflation. In essence a parent can "lock in" their tuition cost at an early age. Most plans require that either the account owner or the beneficiary be a state resident when the account is opened. Anyone can contribute to a prepaid tuition plan.

.Advantages

  • Ability to "lock in" a future expense.
  • Possible hedge against inflation and economic downturns.
  • Some states guarantee the plans.
  • Tax-deferred growth and tax-free withdrawals.
  • Great way for Grandparents to contribute to their grandchild's education.
  • Portability of the beneficiary between family members.
  • Low impact on financial aid eligibility.

Disadvantages

  • Penalties if used for out of state colleges.
  • Earnings may be subject to taxation and penalties if not used for educational expenses.
  • May provide a lower rate of return than a 529 college savings plans depending on market conditions.

Bottom Line

If you live in a state that offers this plan, a prepaid tuition plan is an intriguing choice if your child plans on attending college within that state.

Coverdell Education Savings Accounts

This type of account is formerly known as Education IRAs. Contributions are limited to $2,000 per year until the child reaches age 18. Accounts can be owned by the student or parent. The money must be used by the time the child reaches age 30 to avoid taxation on earnings and a 10% penalty. Investment options are much larger than 529 plans. Contributions are not tax deductible at the federal or state level, but earnings grow tax-deferred. Assets can be used to pay for primary or secondary education expenses along with post secondary education costs.

Advantages

  • Very flexible investment options.
  • Can be used to pay for primary or secondary education.
  • Tax-deferred growth.
  • Low impact on financial aid eligibility.

Disadvantages

  • Can only contribute until age 18 and funds must be used by age 30.
  • Low contribution limits.
  • Coordinating withdrawals can be tricky.

Bottom Line

These accounts can be good tools if you are seeking greater investment options than a 529 plan and don’t plan on making large contributions each year. This is also a good option for parents who want to use the funds for primary or secondary education.

UGMA/UTMA Custodial Accounts

Uniform Gift to Minor's Act (UGMA) and Uniform Transfer to Minor's Act (UTMA) are custodial accounts used to hold assets for a minor until they reach the age of majority. The accounts have been in place before 529 plans and Coverdell ESA's. To establish a custodial account, the donor must appoint a custodian or trustee and then gifts assets into the account. The minor can access the funds as early as age 18 depending on the state. Income must be reported on the child's tax return. Neither the donor nor the custodian can place any restrictions on the use of the money once the beneficiary becomes an adult. Funds are not transferable to another person. There are a larger number of investment options with these types of accounts.

Advantages

  • Very flexible investment options.
  • May shelter a small amount of taxable income.

Disadvantages

  • The child or beneficiary can choose not to use funds to pay for college.
  • Can create tax headaches.
  • Counts heavily against financial aid.

Bottom Line

These accounts can be good tools if you are seeking greater investment options and are not worried about how the funds will eventually be spent once the beneficiary reaches age of majority.

Saving in the Parents’ Names

This category can include anything from savings accounts to retirement accounts to utilizing cash value from a variable life insurance policy. Obviously investment options are very flexible and there are no penalties if funds are not used for college expenses.

Advantages

  • Control of the asset.
  • Maximum flexibility on investment options.
  • Low impact on financial aid eligibility.
  • Fees can be lower than 529 plans.
  • No limitations on the amount that you invest.

Disadvantages

  • Earnings are subject to current taxation and some do not grow tax-deferred.
  • Possibly creates less motivation to save.

Bottom Line

Many parents utilize this option, most by default if they haven’t specifically planned to save in a college savings vehicle. A huge advantage is the fact that the funds can be used for other purposes in the event the child gets a scholarship or decides not to attend school.

Conclusion

One of my favorite strategies is to pair an individual municipal bond portfolio along with a 529 savings plan. Bonds can be bought in a laddered fashion as the child enters college. A 529 plan can be utilized to provide exposure to risk assets like stocks to provide balance to the portfolio. This combination allows a possible state income tax deduction, tax-deferred growth inside the 529 plan and tax-free interest from municipal bonds.

There are numerous ways to plan for education expenses and it’s important to make it a priority to plan as all parents know, our kids grow up too fast!

References

College Advocacy Board and Policy Center. Trends in College Pricing 2013. Available online http://advocacy.collegeboard.org

Bloomberg. College Tuition Costs Soar: Chart of the Day. Available online at bloomberg.com.

Sallie Mae. How America Pays for College 2014. Available online at salliemae.com

New York Times. Student Debt Slows Growth as Young Spend Less. Available online at nytimes.com

DoubleLine Capital. Jeffrey Gunlach Webcast 3/5/2013 "The Big Easy".

For disclosures and index definitions please click here.

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