Children’s College Savings; When, Where, How Much?
You graduated from college and landed the big job you always wanted. You start as a junior associate and begin climbing up the corporate ladder. Then, when you least expect it, the person of your dreams, walks right into your life. You’re thrown for a loop, but the next thing you know, they’re moving all their belongings in and you’re living together. Somehow you wake up and it’s the day of your wedding. The white dress, Calvin Klein tuxedo, champagne toasts, the one awkward uncle who always has a little too much to drink and then your off to an exotic island for your honeymoon. As if life wasn’t moving fast enough, two months later you find out you are going to have a baby!
Babies, they really should come with a manual and maybe even a full time nanny! You’ve got this though, you’ve planned everything out before the big day, right? The nursery is almost ready, the crib is put together, the baby monitor is in place, the closet is full of diapers and you have more onesies than you know what to do with. Right now, the only decisions you’re worried about making involve color pallets for the nursery. Then, the big day comes. You’re a parent now! Reality sets in and you realize you have a human being to nurture and care for. Now your brain starts going a mile a minute. What do we do now? How often should the baby eat? Why is the baby crying? Why am I crying? Can we take the baby out yet? Public school, private school or home school? What about college!? How on earth are we going to pay for college!? I personally can’t help you answer the first round of questioning, but college, and how to pay for it, I can help you with that.
One of the most common questions I hear from new parents is, “How do we pay for college?”. It’s an understandable concern when you realize that the cost of college increases substantial every year. According to finaid.org, during any 17-year period from 1958 to 2001, the average annual tuition inflation rate was between 6% and 9%, ranging from 1.2 times general inflation to 2.1 times general inflation. On average, tuition tends to increase about 8% per year. I’m not an economist, nor do I want to assume I know everything about your life, but I doubt you’re consistently getting 8% raises every year at work. That’s the bad news. The good news is you have options and I’m going to give them to you below.
In this article, I will weigh the pros and cons, of five different savings strategies for your child’s college funding. I will discuss in detail exactly how each solution works and how it affects considerations for other needs-based grant programs. I will also talk about the liquidity and flexibility of each plan, as well as the tax ramifications of each strategy. Before I dive into the different solutions, I want to say something about prioritization. Prior to putting money away for your children’s education, I ask that you make sure that your personal balance sheet is in order. All too often, I see parents putting money away for their children, earning 5–6% in the markets, while at the same time, trying to pay down debt that is costing them 15–20%, or without proper life or disability insurance in place. I want you to make sure that you have sufficient savings on your balance sheet, little to no short-term debt, and proper protection in place before you focus on an event that is 18 years down the road. With that said, let’s jump into it!
State Tuition “Pre-Paid” College Plans — Before deciding on whether to utilize a pre-paid college plan, I highly suggest that you research heavily your particular state’s plan. Being that I live in Florida, I will speak in regards to Florida’s pre-paid tuition plan. Before I do that, I will go over some characteristics that are universal to all pre-paid tuition plans. One major benefit of pre-paid accounts is that the earnings accumulate tax deferred and may be used entirely tax-free if used for qualified higher education expenses. Pre-paid plans also aren’t susceptible to market volatility. Yup, no sleepless nights during bad markets. In my opinion, that’s where the benefits of pre-paid plans end. Pre-paid plans allow no flexibility, nor do they offer liquidity. They force individuals into a cash flow commitment, which could prove detrimental should a family have some cash flow issues for a period of time. There are also penalties involved if the funds are not used for qualified higher education expenses. The plan does allow you to transfer ownership from one child to another, which could prove helpful if one of the children decides school isn’t for them.
Now, let’s talk specifically about the Florida pre-paid tuition plan. As of this year, tuition for Florida residents at the University of Florida is $212.71 per credit hour. In timely fashion, my lovely wife gave birth to our son Erion in April of 2016. To make things simple, I will use him to illustrate my point moving forward. To enroll my son in the 4-Year Florida University Plan would cost us $191.72 a month. The first payment would be due April of 2017 and our last payment would be in October of 2034, that is a total of 210 payments. Add that up and I am looking at paying $40,261.20. Divide that by 120 (the number of credit hours it takes to graduate) and you get $335.51 per credit hour. That is an additional $122.80 per credit hour over the current rate. We have to remember as well, that this covers the cost of tuition only. You still have to worry about room and board, meals and of course, beer money. I personally have decided against this option for my children. If you took the same $191 and placed it in a brokerage account, you would have more flexibility and also liquidity. Let’s assume that the brokerage account yielded only a 5% annual rate of return over an 18-year span, you would end up with approximately $68,000. You would also end up with something that the prepaid account doesn’t give you, options.
529 College Savings Plans — A 529 plan or a “qualified tuition plan” is a state sponsored savings plan that must be utilized for qualified educational expenses. You are not restricted to a particular state while using a 529 plan. For example, you can be a Florida resident, invest in a North Dakota 529 plan and have the beneficiary attend school in Illinois. 529 plans are generally praised for being low fee, but that doesn’t include the fees paid inside their mutual fund accounts. 529 plans generally have limited investment options as well, which could make it difficult to find one that meets your investing needs. Also, a 529 plan invested in the market is not immune to market volatility or market downturns. In 2008 and 2009, some 529 plans lost up to 30 percent of their value just as the beneficiary was getting ready to attend school. Again, managing the risk inside these investment vehicles is crucial. As your child approaches college age, it may be best to switch to a more conservative investment allocation to reduce the chances of a large loss just before you need the money. Being that 529 plans must be used for college expenses, they offer less flexibility and liquidity than other options. Should you withdraw money from a 529 plan for any reason other than a qualified educational expenses, you will be assessed a 10% penalty and also pay income taxes on the amount withdrawn. You do have the ability to change the beneficiary of the account from one child to another, should your child forego college. From a student aid perspective, FAFSA only considers the account as 5.64% of a family’s expected contributions. This is much more favorable than the 20% consideration a “pre-paid” plan creates.
UTMA (Uniform Transfers to Minors Act) or Custodial Accounts — Custodial accounts are accounts set up by adults on behalf of a minor. These accounts are generally housed at a bank or a brokerage firm and have a wide range of investment options, including stocks, bonds, CD’s and mutual funds. A parent DOES NOT have to be the custodian of the account, nor do they have to manage the account. Once a minor becomes of legal age, the account is transferred over to them. You can see how this can be an issue as these accounts don’t have to be used specifically for educational purposes. On the other hand, if your child does not attend college, this route could be suitable as you will avoid the penalties other options create. These accounts are highly liquid but are not tax deferred, so some of the gains in the account can potentially be taxable each year. Again, the risk with a market-based investment account is volatility and the chance that the market could be down when you need the money. A major consideration to this strategy is FAFSA’s consideration of the account. The assets held in these accounts are considered to be the minor’s and therefore may reduce the amount of money available through other financial aid channels. FAFSA’s consideration for custodial accounts is 20% of the account value. There is no contribution limitation in regards to who can fund the account, but the maximum an individual may contribute under the gift tax exemption is $14,000 for 2016. Another characteristic to custodial accounts is that there is no forced commitment of savings. That could be beneficial for some and may be the demise of others.
Segregated Investment account — A segregated investment account, is nothing more than a typical investment account that has been opened at your local brokerage firm or even through online platforms, such as E-Trade. This account may be used for purposes other than education and just like a custodial account, it has no tax deferred characteristics. That’s right, you’ll be paying taxes on the growth. Investment accounts are highly liquid so you can withdraw money whenever you choose to do so for any reason without worry of penalties. There is no contribution limitation, nor is there a forced commitment of cash flow. Investment accounts share a lot of the same characteristics as custodial accounts, including that of market volatility. Managing the risk inside this vehicle is crucial if the intent of this strategy is to provide college funding. As you begin to reach the end of the child’s high school years, you may want take a more conservative approach in the portfolio. Failure to do so could leave you vulnerable to major down turns in the market right when the money is needed. One of the major issues when utilizing investment accounts for educational purposes is that they are not definitively ear-marked for the children who will be using them. Parents who face hard times would have complete access to these accounts and may be tempted to use them. They will do so with no apparent or immediate penalty or major tax consequence, but the funds would no longer be available to pay for college. Again, leading back to my original warning, make sure your personal financial house is in order before setting up college funding plans. In regards to FAFSA consideration, only 5.64% of the account is realized as an asset to the child.
Life Insurance Contracts — Cash Value Life Insurance policies offer families a savings vehicle with the flexibility to use the funds where ever they see fit and also offers families a tax free benefit. Utilizing life insurance as a part of your college savings plan has many benefits. One of those benefits is that FAFSA does not recognize any of the money inside the contract as an asset. Good cash value life insurance contracts generally begin to build momentum and liquidity after the first year. There is a forced savings component in life insurance contracts, but they begin to have some funding flexibility after the first couple years in the event the family should fall on hard times financially. The IRS does have contribution limits inside life insurance contracts due to their tax advantaged nature. Although these thresholds are fairly high and differ depending on individual contracts, one must be careful not to over fund these policies and lose their tax advantaged nature. Some life insurance contracts called “participating whole life policies” do not suffer from market volatility. They have a guaranteed contract value and also have the ability to earn dividends. Historically, growth inside a good participating whole life insurance contract is around 4–5% percent, a return many would be happy with for an investment guaranteed to never lose value. Selecting a financially stable insurance company is key to maximizing benefits and growth in your contract. I recommend using a mutual life insurance company. Should you need to use the funds earlier than you had anticipated or use the funds for something other than education, you will not be penalized. Every life insurance contract is assigned to one specific child and can’t be assigned to a sibling. That does not mean that the funds inside the contract have to be withdrawn and used only for that child, you have flexibility.
Summary — There are a lot of considerations and decisions to make in regards to planning for your child’s future. You have to decide on a personal level which one of the above options best fits your family’s needs and abilities to save. Outside of the above stated facts, I suggest you think about scenarios that could be very real when your child is going to approach college age. Is your child going to attend college for sure? Is the structure of college going to be the same 15 plus years from now? Will all college be online in the future? Will the government take over and control the cost of college? What if my child wants to study abroad? There are a lot of unknowns and I suggest you highly consider an option that is flexible and fits you and your child’s needs. If you have any questions or concerns, feel free to email me at Erakipi@westshorefinancial.com