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 $605 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 10-year-old, you would need to save about $1,269 monthly under the same assumptions, which is more than double.
There are two primary vehicles to save for education: Section 529 college savings plans (529 plans) and custodial accounts, otherwise known as Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (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 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 2022 is $16,000 per donor per recipient. This means you can give up to $16,000 per child each year without needing to file a gift tax return (or $32,000 per child when combined with your spouse).
Advantages of 529 plans
Withdrawals are tax-free if used for education, including college, graduate studies, and up to $10,000 per child per 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 education expenses).
There is an opportunity for five-year front-loading of gifts. Instead of contributing the annual exclusion amount (currently $15,000 in 2021 and $16,000 in 2022) to the student’s 529 plan each year, you could make up to five years’ worth of gifts ($75,000, or $150,000 if combined with your spouse) all at once. This allows for the potential of more tax-free growth on the assets. If you were to die before the end of the five years, a pro rata share of the contributions would be brought back into your estate for purposes of calculating potential estate taxes. However, under current tax law, estate tax 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 years if qualifying for financial aid is a concern (the Free Application for Federal Student Aid, or 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.
In 2022, if the child is younger than 18, the first $1,150 is untaxed, and the next $1,150 is taxed at the child’s rate. Anything over $2,300 is taxed at the parent’s rate. 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 education 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 2022-23 school year, the application must be received by June 30, 2023. However, you should complete this as soon as possible to ensure maximum eligibility for scholarships. Many schools require this information by March 1 for them to prepare a financial aid offer before national decision day on May 1. Income amounts are based on your 2020 income tax return. Asset values are as of the date you complete the form. The entire process can be completed online at studentaid.gov. You should file 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 (EFC). This is the amount you are expected to pay toward 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 toward 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 years.
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 that may have changed.
There is another form called the CSS Profile that some private schools require. It is even more time-consuming than the FAFSA in that it asks for more detailed information and lacks a data retrieval tool for getting information directly from the IRS. However, it is necessary for your student to qualify for scholarships at certain schools, so be sure and check with each one. Just be sure to allow yourself enough time.
Be aware of the differences between subsidized versus unsubsidized loans. Subsidized loans have a lower interest rate, so unsubsidized are less desirable.
This really starts junior year, but the principles still apply. Test early and often. Don’t be afraid to reach out and get help for your student. Our son has always struggled with standardized tests, and he knows it, so taking these just stressed him out further. The good news is that it doesn’t count against your student to take an exam multiple times, which was frowned upon many years ago.
We used both a study skills tutor and an academic tutor, both one day a week. Our son did this for several months and was able to raise his ACT composite score by seven points, which really opened some doors for him regarding admissions.
Test optional? Not really
While I have read that many schools are de-emphasizing standardized tests, we did not find that to be the case. I found information on lists of test-optional schools that was often inaccurate, and there were other catches. For example, NYU is test optional, but if your student doesn’t provide an ACT or SAT score, they must submit three AP exam scores, including one in math or science. Our son had two AP scores and was taking his third AP course, but none were in math or science. Since he is already a senior and his courses set in place, there was no way for him to qualify. Had we known this during his junior year, he could have adjusted his course schedule accordingly.
Deadlines, deadlines, deadlines
Here’s an area where you can really help your child. There are so many deadlines, it’s hard to keep them all straight. Every school’s application deadline is different. Some also have separate deadlines for scholarship applications. For example, Virginia Tech (his leading choice) has a huge number of scholarships that you must apply for individually, all with different deadlines. Other institutions just let you know of a scholarship as part of their application process.
We had him apply early action for all schools; to us it seemed like the regular deadlines were too late to give him a good selection for housing. The early action application deadlines were generally between November and January. Many applications require essays; some may be reused but others are unique to the institution. Make sure your student knows which schools require essays and help keep them on top of the deadlines.
Don’t nag them — just make a master list and follow up with them from time to time to keep things moving and make sure they don’t miss anything.
How will we adjust when our oldest leaves? Well, we have another boy in highschool, so we’ll do it all over again in a few years. He’ll have a head start on the college tours, although his interests are totally different than his brother’s. It will be bittersweet for us; we will miss our oldest, and the house won’t be the same. But we’re happy that he’s entering a different phase of life and are excited to see where he ends up. And our youngest will enjoy being an only child for a while.
Good luck, and as our son’s guidance counselor said, “It will all work out!”
*Assumes: $24,546 current annual education cost (tuition, books, fees, room & board); 5% annual inflation; 7% annual total return.