Tag: Education

If you have a child, you’ve probably put some thought into their future. And a big part of that future, at least for many kids, will be a college education.

When I calculate the future cost of a four-year education at an in-state public institution for a newborn, I am finding that it’ll take nearly $250,000 for them to earn a bachelor’s degree. And the cost of attendance only continues to rise!

Luckily, children have multiple ways to fund education either through part-time jobs, grants, scholarships, or student loans and they have many earning years ahead of them to afford financing education.

However, you can begin saving toward their education now to help pay for some of those future expenses and reduce the amount of debt your child will have to incur.

Below are some of the ways you can begin saving for your kid’s education.

Side Note: Before you just begin saving, make sure you have a clear picture of what you are saving for. I have an education funding conversation with my clients before they open any type of account. We explore their philosophy toward funding education for their children, what type of college they want to save for (private vs. public), and how much they want to fund (50%, 100%, certain dollar amount). Then I run an education funding analysis which calculates how much they need to save to fund their education goal.

529 Savings Plan

A 529 is an education savings plan. It allows you to invest money into an account, let it grow tax-deferred, and then withdraw it for qualified education expenses without having to pay taxes on it. It’s a pretty sweet deal.

The funds in 529 accounts can be used for any eligible institution, in any state, so there won’t be any issues if your child decides to go to school somewhere other than the state your 529 is in.

In fact, the money can even be used for foreign schools or vocational schools if college isn’t right for them.

Some states even offer incentives for contributing to their 529. Indiana taxpayers can get a state income tax credit equal to 20% of their contributions to a CollegeChoice 529 account, up to $1,000 per year.

Usually, the amount you can contribute in total to a 529 plan is pretty high (up to $450,000 per beneficiary in Indiana) but will vary by state.

If you end up with unused funds in a 529 plan, these can easily be transferred to other children or any other family member to use for qualified education expenses.

However, if the funds aren’t for qualified education expenses, withdrawals will be subject to a 10% penalty, taxed as ordinary income, and any previously claimed tax credits may be owed back.

As a result of these tax implication, it is generally recommended to avoid over-funding 529 plans.

Roth IRA

I’m often asked if it makes sense to use a Roth IRA to save for college in case a child decides not to go to college. Yes, it is possible to use a Roth IRA as a combined college and retirement savings vehicle.

When needed to pay for college expenses, you simply limit withdrawals to the contributions in order to avoid paying any income taxes on the distribution. The earnings remain in the Roth IRA to pay for retirement.

Keep in mind there are limitations to using a Roth in this manner.

First, there are income limitations to contributing to a Roth IRA. In 2019, a couple that earns more than $193,000 ($122,000 for those who file single) begin to be phased out of making contributions. Above $203,000 ($137,000 for single) and you can’t contribute at all.

Secondly, those under age 50 can only contribute $6,000 to a Roth IRA each year (2019 limits).

The main problem with this approach though is the distributions count as untaxed income on the following year’s FAFSA, reducing eligibility for need-based financial aid.

It also reduces lifetime tax-free accumulations, which are particularly valuable in retirement.

Tax-Advantaged Account

Another funding option is to save to a tax-advantaged investment account (joint, individual, or trust) since these types of accounts don’t have contribution limits.

This would be similar to saving to a Roth IRA in that you could keep the money in the account and use it for retirement if your child does not attend college.

However, you still run into the possible financial aid issues that you do with the Roth IRA and you might miss out on your state’s tax incentive.

Optimal approach

In my opinion, the optimal approach would be to fund the 529 first, especially if there is a state tax incentive available. Once the 529 funding is deemed to be nearing an appropriate level based on your goals, you can save additional college funds via a Roth IRA and/or a tax-advantaged investment account (joint, individual, or trust) to ensure maximum flexibility among your various financial goals.

It is important to note that very few people fully fund their children’s education savings accounts, such as the 529, and you shouldn’t feel pressured into believing you have to in order for your child to succeed.

Like I mentioned above, children have a lot of ways of paying for their own education and — I can say from my own experience — working during college can help keep them on track.

If you have a child, you’ve probably put some thought into their future. And a big part of that future, at least for many kids, will be a college education.

When we calculate the future cost of a four-year education at an in-state public institution for a newborn, we are finding that it’ll take nearly $250,000 for them to earn a bachelor’s degree. Talk about expensive!

Luckily, children have multiple ways to fund education either through part-time jobs, grants, scholarships, or student loans and they have many earning years ahead of them to afford financing education.

However, you can begin saving toward their education now to help pay for some of those future expenses and reduce the amount of debt your child will have to incur.

While there are many ways to save for your kid’s education (savings accounts, UGMA & UTMA accounts, Roth IRAs), my opinion is that a 529 plan is the best.

What is a 529 Plan?

A 529 is an education savings plan. It allows you to invest money into an account, let it grow tax-deferred, and then withdraw it for qualified education expenses without having to pay taxes on it. It’s a pretty sweet deal.

There are two types of 529 plans: prepaid tuition plans and education savings plans. This post will focus solely on the education savings plans as they can be used for any qualified college or university.

Select My State’s Plan or Shop Around?

Contrary to popular belief, you can use almost any State-sponsored 529 plan. Not just the state you live in. With so many choices, it can be hard to decide whether to use your own State’s 529 plan or another one’s.

There are a few things that you should consider when determining which State’s plan is right for you: the investment options that are available to you, the fees associated with the plan, and any tax incentives that your State offers.

Investments

You might hear a lot of emphases put on evaluating the past performance (3-yr, 5-yr, 10-yr average annualized returns) to determine if you should go with a plan. While you do want a plan that has a good track record, this backward-looking metric has no indication of how well the funds will perform in the future.

Instead, you’ll want to focus on the managers of the funds themselves and the way they are positioning the funds for long-term financial gains. This will help you determine if the plan has viable investment options that are suitable for you to achieve your goals.

Fees

Probably more important than the performance numbers are the fees for the plan. Fees have a huge impact on ending account value. The higher the fee, the less money you have in the future. Carefully evaluate the overall fees for the plans you are comparing.

It isn’t always wise to select the cheapest option either. It is possible that the plan manager is offering a higher level of investment management, which aligns more closely with your investment style, making the higher cost worth it to you.

Tax Incentives

Many states offer tax incentives to its taxpayers who contribute to 529 plans. For example, in Indiana, taxpayers are eligible for a state income tax credit of 20% of contributions to its 529 accounts, up to $1,000 credit per year. That means you’ll need to contribute at least $5,000 per year to take full advantage of the credit.

Tax incentives shouldn’t really be a factor when determining which State’s plan to go with if you won’t be contributing enough to get it in the first place.

Always Direct.

No matter which State’s plan you go with, you are going to have the option to go through a broker to open the account (advisor-sold) or do it yourself (direct-sold). You’ll always want to go with a direct-sold plan. The advisor-sold plans have higher annual costs because the broker is getting paid a commission for doing the same work that you can easily do.

If you have questions about selecting the right 529 plan, or how to evaluate a plan’s fees and investments, I recommend seeking out a fee-only financial advisor for help. They’ll be able to help you determine a savings goal and then evaluate which State’s plan matches your needs.

A question that often gets asked is if 529 accounts can be used to repay student loans. Technically the answer is yes, but there are major drawbacks in doing so.

You can use a 529 account to pay for tuition, fees, room and board, books, computers, and other “qualified” education expenses without tax implications or penalties.

However, student loan payments are not considered qualified expenses.

The earnings on non-qualified withdrawals are subject to federal income tax and may be subject to a 10% federal penalty tax, as well as state and local income taxes. Also, many states have a recapture or “clawback” provision that will make you pay back any tax breaks you received.

PRO TIP: If a non-qualified distribution occurs from a 529 account, the tax credit recapture is assessed to the owner of the account regardless of who actually contributed the funds and received the original credit (e.g., grandparents have been contributing to the account and claiming the credit but you own the account, you are liable for the recapture).

What if the rules change?

Earlier this year, the House Ways and Means Committee unanimously passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act.

While not official yet, the legislation does propose expanding the benefits of 529 college savings plans, including adding principal and interest payments toward student loans as qualified education expenses — up to a lifetime limit of $10,000 per 529 plan beneficiary.

This would be a huge benefit for parents who have leftover money in their child’s 529 accounts after they have already graduated.

Families in this situation now only have two options:

1. transfer the funds to other children or another family member to use for qualified education expenses, or
2. accept the tax liability for non-qualified withdrawals.

Having the flexibility to use the 529 accounts for student loans payments would not only increase the 529’s utility for families in this unique situation but even independent, working adults who still have student loans.

Strategy for independent adults

If you’re an independent taxpayer (meaning you can’t be claimed as a dependent on anyone else’s tax return) you can deduct interest on student loans paid by you, or by your spouse if you file a joint return.

Like many tax breaks, the student loan interest deduction is designed to provide tax relief to Americans with low to moderate incomes.

The ability to take the deduction begins to phase out above a certain MAGI (modified adjusted gross income) level.

If your MAGI is under the threshold where the phase-out begins, you can deduct up to $2,500 in student loan interest or the actual amount of interest you paid, whichever is less.

PRO TIP: The deduction is capped at $2,500 in total interest per return, not per person, each year. In other words, if you’re single, you can deduct as much as $2,500 of student loan interest. However, if you’re married and file a joint return, you and your spouse can only deduct a total of $2,500, even if both spouses have student loan debt.

If you earn between $70,000 and $85,000 as a single filer or between $140,000 and $170,000 as a joint filer, you’ll qualify for a reduced amount of interest deduction less than $2,500. 

Unfortunately, your student loan interest isn’t deductible at all if your income is more than the ceiling where the phase-out ends. 

While the student loan interest deduction can be very valuable (if you even qualify for it) it’s possible that your state offers a tax incentive for contributing to a 529 plan that is more beneficial than the interest deduction. 34 states currently offer a state tax credit or deduction for contributions to a 529 plan.

Depending on the tax benefit your state is offering, it could make sense to fund a 529 account, earn the tax benefit, and then use the 529 account to pay your student loans.

PRO TIP: There are no age restrictions for 529 accounts which means anyone over the age of 18 can open a 529 and name themselves the beneficiary.

You can generally claim a state tax benefit no matter how long the money is held in your 529 plan. So instead of paying tuition straight from a bank account, you can funnel the money through a 529 plan in order to claim the tax benefit.

Hypothetical example

Let’s assume you’re an Indiana resident and your student loan payments equal $5,000 per year, $2,500 of which is interest.

Indiana taxpayers (resident or non-resident, married or individual) are eligible for a state income tax credit of 20% of contributions to a CollegeChoice 529 account, up to $1,000 credit per year.

You can either pay the $5,000 student loan payments out of pocket and claim the $2,500 interest deduction on your Federal return or use the 529 account strategy to claim a tax credit on your Indiana return.

PRO TIP: Tax code prohibits double-dipping when it comes to claiming multiple credits or deductions for the same expenses in a single year, so student loan interest payments made using a 529 account will not be eligible for the student loan deduction.

Based on our example, using the 529 plan to funnel the student loan payments through saved an additional $450 in taxes. Not too shabby!

The potential tax savings would be even greater in a scenario where the person was above the income threshold for the interest deduction, as 529 plans don’t have income limits and even the highest earners can contribute and receive available tax benefits.

While this strategy is purely hypothetical right now, I do think it has merit if the SECURE Act becomes law.

I will definitely be keeping my eye on the progress of the bill!