Financial Geekery

Saving for education

April 23, 2018

So you've got a child, and -- after the initial euphoria of the whole childbirth-or-adoption experience has worn off -- you've started to worry about the mounting costs of a college education. Good on you for planning ahead! From how much to save to where to stash your savings, here's what you need to know.

 

How much should I save?

 

Between grants, loans, and scholarships, there are a lot of options for financing a college education, so it's not strictly necessary for you to be able to pay for six years at Vanderbilt if it's not something that your budget can handle. When working with clients, I generally recommend they set a target -- say, three years at an in-state public university -- and save towards that goal, with the understanding that anything beyond that will be financed. If your circumstances change (for better or for worse!), you can adjust the target accordingly.

 

When the time comes to crunch the numbers, a great resource for running the numbers on college education is the National Center for Education Statistics's College Navigator. They can give you a solid breakdown of the total price tag for a year at any given university. Of course, you need to account for inflation in college prices, as well: College Board has a good resource on the rate of education inflation broken down by type of institution, but be aware that this is the amount above and beyond normal inflation. For example, if inflation as measured by CPI is 3.0%, and the above article lists average inflation-adjusted percentage increase as 3.2%, this means that the cost of education rose 6.2% annually in that decade. Currently, they're recommending you use 5%-8% as the estimation, moving forward.

 

Where do I put the money?

 

You've got several options when it comes to saving for college. I'll spend a little bit of time talking about the ones I generally don't recommend, then talk more about the one I most often like best.

 

IRA's can be used for qualified education expenses. Both Traditional and Roth IRA's generally get you slapped with a 10% penalty (above and beyond the normal taxes on a Traditional IRA distribution) if you withdraw before age 59.5. However, qualified family education expenses -- tuition, fees, books, supplies, equipment, and room & board -- are exempted from that penalty. Note that in the case of a Traditional IRA, you are still taxed (just not penalized) on the withdrawal, and if you've had a Roth IRA for five years you can withdraw your Roth contributions (not earnings) for any reason, not just education.

 

However, both of these are better used for your retirement; while there are financing options aplenty for college, the same can't be said for retirement. Good on you for wanting to sacrifice your well-being for your child's, but think of it this way: it's not really a sacrifice if you're just forcing them to support you later on, when your retirement savings run out!

 

You can also take out a loan from your 401(k). You can borrow the lesser of $50,000 or half of your current balance from your 401(k) account. However, this isn't like borrowing from a friend -- there are strict repayment terms often enforced by payroll deductions, and if you don't adhere to those terms, you'll get hit by the aforementioned tax-plus-penalty. Not to mention there's the obvious irony of taking on debt to avoid debt. (Yes, you are paying the interest back to yourself, but note that unlike normal 401(k) contributions, the interest payments aren't tax-deductible.)

 

There is also the option of a prepaid tuition 529 plan. Each state has their own education savings plans under section 529 of the Internal Revenue Code. Some states offer prepaid tuition plans, though it's a dying breed (with Texas being one of the remaning holdouts). With these plans, the idea is relatively simple: you can pay for units of tuition using today's dollars, effectively guaranteeing that your education savings will rise with education inflation. 

 

This isn't a bad option: a guaranteed 5-8% return on investment (see the above note on education inflation) beats most other risk-adjusted ROI's out there. However, these plans are only valid for the state in which they're purchased; while you can transfer the money into an out-of-state plan, you'll often be penalized for doing so, either with a fee or with reduced credit purchase. Also, be aware that these are prepaid tuition plans; they don't cover books, supplies, equipment, or room & board.

 

My favorite option: a 529 savings plan. 

 

With a 529 savings plan, you invest your money in an account with several investment options, similar to a 401(k). The money grows tax-free, and withdrawals for qualified education expenses (again: tuition, books, supplies, equipment, and room & board) are untaxed. If your state has income tax, you'll generally get a state deduction for contributions, as well.

 

Other than the requirement that it be for qualified education expenses, there are very few strings attached: you can use any state's 529 plan to pay for any state's public or private university expenses (and even some in other countries)! So if you live in a state with no income tax -- like, say, Texas -- you can go shopping for your personal favorite 529 plan, with the lowest fees and best investment options.

 

And which 529 would that be? I highly recommend Utah's my529 program, formerly known as UESP. Their fees are astronomically low, they have a solid mix of options by Vanguard and Dimensional Fund Advisors (if you haven't heard of them, it's because they're not available to retail investors; here's a primer on DFA from the Wall Street Journal), and the investments are extremely customizable, allowing you (or your financial advisor) to design the perfect portfolio. Plus, they're improving every year, often adding investment options and/or lowering their fees. 

 

(Sidebar: I'm not affiliated with Utah or DFA. I just call 'em like I see 'em.)

 

If you've got a lot of money already set aside that you can throw into a 529 plan, be aware: contributing to a 529 plan is considered by the IRS to be a gift. In other words, as of this writing, anything beyond $15,000 per year per donor per donee counts towards your lifetime estate tax/gift exclusion. However, also be aware that a 529 contribution can be "superannuated", such that you can combine five years' worth of contributions into one year. For example, if you and your spouse have $300,000 set aside in a savings account for your two children's college expenses, each of you can donate $75,000 to each of their 529 plans, allowing you to place the entire amount into 529 funds without a dime of it counting towards your lifetime exclusion.

 

What if you don't use all of your 529 funds? If your child doesn't go to college -- or if they get more scholarships than you anticipated -- the easiest solution is to simply reassign the beneficiary; the IRS allows you to change the beneficiary of a 529 without penalty to any member of the beneficiary's immediate family, including their sibling, parent, child(-in-law), niece/nephew, uncle/aunt, or cousin!  So you could always reassign the 529 funds to a sibling, or even keep them around for your eventual grandchildren.

 

Something to bear in mind here: while the rules vary from plan to plan, most 529's only allow for one beneficiary change per year. So if your children might end up going to college at the same time, you may want to have a separate account for each of them. However, if your children are more than 5 years apart, it's certainly a viable strategy to overfund the older sibling's account and then transfer the remainder to the younger sibling, to ensure maximum utilization of 529 funds.

 

If you find that you really want to access the funds in a 529 plan for non-educational purposes, you'll face the standard IRS fine mentioned earlier: the withdrawal is taxed as income, with a 10% penalty on top.

 

What about the effect on financial aid? Some clever folks will ask me about the effect of 529's on financial aid. Specifically, when determining grants and/or loans, Federal Student Aid determines your need based on a simple calculation: Cost Of Attendance minus Expected Family Contribution. The higher your EFC, the lower your financial aid. You can find the exact formula on FSA's web site,

 

So, to answer the question: currently, the formula states that a maximum of 5.64% of a parent's nonretirement investment assets (including any 529 plans they've opened) are included in EFC. If e.g. a grandparent owns the 529, the assets don't count at all...for the first year. However, withdrawals from a 529 plan not owned by the student or parent but used to pay for the student's educational expenses are considered income, and thus increase EFC by up to 47% of the amount withdrawn. The same rule applies for IRA's -- they don't count at all when you initially apply for financial aid, but any withdrawals count as income for EFC purposes.

 

And those are the highlights on saving for education! As always, these articles are "80/80" -- appropriate for 80% of my audience, 80% of the time. Got a situation that isn't quite covered above? Don't hesitate to leave a comment or send an e-mail!

Please reload

Subscribe

RSS Feed

Recent Posts

Please reload

Archive

Please reload

Tags

Please reload