College savings is a topic near and dear to my heart, as we have a 17 year-old who is currently undergoing the college exploration process. It seems like just yesterday we dropped him off for his first day of kindergarten. He looked so small walking into that big school with his little turtle backpack on, my wife and I both had tears in our eyes. Now he is towering over us at 6’2”, constantly eating, and never gains weight.
Many people do not have sufficient education savings for their children. How much you need to save depends on a variety of assumptions such as the current cost of education, the inflation rate of these costs and the rate of return on your education savings. For a child born today and attending UNC Chapel Hill at age 18, you would need to save about $581 per month until they begin college.* The key to success is to start saving early and regularly. The longer you wait, the harder it is to make up lost ground. For a ten-year old, you would need to save about $1,183 monthly under the same assumptions, which is more than double.
There are 2 primary vehicles to save for education: Section 529 college savings plans (“529 plans”) and custodial (otherwise known as UTMA or UGMA) accounts. There are also prepaid tuition plans and Education IRAs/Coverdell accounts, but these are not as common. The more important thing is to start now and save regularly rather than which particular vehicle you decide to use. Or, like many people, you can use a combination of both 529 plans and custodial accounts. Both types of accounts are typically funded by annual exclusion gifting from parents or grandparents. The annual exclusion gifting limit in 2019 is $15,000 per donor per recipient. This means you can give up to $15,000 per child each year without needing to file a gift tax return (or $30,000 per child when combined with your spouse).
Advantages of 529 Plans
Withdrawals are tax-free if used for education (college or later, or up to $10,000/child/year for elementary and secondary school or homeschooling expenses).
Assets are out of the account owner’s estate but the owner retains control (they can change the beneficiary to another family member or withdraw assets, but withdrawal may have penalty and tax consequences if funds are not used for qualified educational expenses).
There is an opportunity for 5-year front-loading of gifts. Instead of contributing the annual exclusion amount (currently $15,000) to the student’s 529 plan each year, you could make up to 5 years’ worth of gifts ($75,000, or $150,000 if combined with your spouse) all at once. This allows the potential for more tax-free growth on the assets. If you die before the end of the 5 years, a pro-rata share of the contributions are brought back into your estate for purposes of calculating potential estate taxes. However, under current tax law, estate tax only affects very few households.
If you are a grandparent who’d like to help your grandchild, you can consider funding a 529 plan for your grandchild. If the account is in your name, it is not considered part of your grandchild’s assets for qualifying for financial aid. However, any distributions used to fund the child’s tuition would be counted as income for the child and so should be delayed until the student’s junior and senior year if qualifying for financial aid is a concern (FAFSA uses prior-year tax data).
If there are excess funds left over after the beneficiary finishes their education, the account owner can change the beneficiary to another family member, such as a younger sibling.
Advantages of Custodial Accounts
These accounts have more freedom of use and flexibility. They can be used for anything at any time, not just education expenses.
Parents or grandparents can gift appreciated stock and have the child sell small portions at 0% capital gains tax. This is in contrast with 529 plan contributions, which can only be made in cash.
As part of the tax reform effective in 2018 a child’s tax rate is no longer affected by the parents’ income. For a child without earned income, the first $2,600 in investment income (dividends, interest and capital gains) is free of Federal income tax. The next layer, up to $12,750, would be taxed at 15%. The idea is to sell assets at capital gains tax rates that would be lower than that of the parent or grandparent. Note that state income taxes may still apply, although these are not as significant of a factor.
For a child without earned income in 2020, the first $2,200 in unearned income (including dividends, interest and capital gains) is free of Federal income tax. The idea is to sell assets at capital gains tax rates that would be lower than that of the parent or grandparent. Note that state income taxes may still apply, although these are not as significant of a factor.
Custodial accounts can also be used as a tool to teach kids about investing. Let them pick a couple of stocks they are familiar with that pay dividends and watch them perform over time.
Disadvantages of Custodial Accounts
Funds in the account legally become the child’s assets once the child reaches the age of majority (21 in North Carolina). You cannot change the beneficiary as you can with a 529 plan. However, you can regulate the amount in the account by using the funds to pay expenses that benefit the child. In addition to educational expenses, this could be anything from a computer for school, summer camp, a car, etc. Or, once they have earned income, moving assets from the custodial account to a tax-free custodial Roth IRA would be an option.
In addition, the funds are considered the child’s assets for financial aid purposes. Therefore, the funds could count against them.
What about Financial Aid?
According to FinAid.org, people tend to overestimate the amount of merit-based aid and underestimate the amount of need-based aid they might receive. Eligibility for financial aid is a calculation with a number of moving parts, and there is no set level of assets or income that would preclude you from receiving financial aid.
The first step in the process is to complete the Free Application for Federal Student Aid (“FAFSA”). For the 2020-2021 school year, application must be received by 6/30/2021. Income amounts are based on your 2018 income tax return. Asset values are as of the date you complete the form. The entire process can be completed online at: https://studentaid.ed.gov. You should file anyway whether or not you believe you will qualify for benefits.
The income and asset values submitted on the FAFSA are used to compute your Expected Family Contribution (or “EFC”). This is the amount you are expected to pay towards your student’s education. The calculation is quite complex, and the specific EFC depends on a variety of factors including the cost of attendance, specific assets and income of both the parent(s) and the student, and the number of children in college at the same time.
In the calculation, only certain assets count in determining the EFC. For example, IRAs and other retirement accounts are excluded, as is equity in the family’s principal residence. 529 plans are considered assets of the account owner (the parent or grandparent), not the beneficiary. Custodial accounts are considered an asset of the child, meaning the child’s assets count for more than a parental asset (they raise the EFC), or assets such as a 529 account owned by a grandparent (which wouldn’t count at all towards the EFC). However, as previously mentioned, any distributions from a grandparent-owned 529 plan would be counted as income for the child and so should be delayed until the student’s junior and senior year.
Potential financial aid is calculated as the estimated cost of attendance minus the EFC. You should fill out the FAFSA in subsequent years even if you don’t qualify for any aid in a particular year, since there are many circumstances which may have changed.
Now is the time to get started or increase your education savings!
Bill Hansen, CFA
President and Chief Investment Officer
*Assumes: $22,863 current annual education cost (tuition, books, fees, room & board); 5% annual inflation on education costs; 7% annual total return on education investments.