Study hard, get good grades, go to college. My parents said this to me, and their parents said it to them. Historically, a college education has been the path to upward mobility and a better life. This still remains true, but with the cost of college increasing so rapidly, many worry that the dream may drift out of reach. Think about it: According to The College Board, tuition, room and board, and fees for one academic year at a four-year public college have grown from $8,439 in 2000–2001 to more than $20,000 this year. For private institutions, that total has nearly doubled to $46,000 per year.
I have seen families go to extremes to send their children to college. Some have taken out loans so large that it will be years before they are repaid. Others have borrowed from their retirement savings. While at first it appears easy to borrow against one’s 401(K), it is important to remember that these funds must be paid back, and not doing so can have serious consequences for your own retirement plans. Some families hope to rely on loans taken out by the child, but this can saddle a young college graduate with an immense debt burden when he is just starting out on his own. Astonishingly, the New York Federal Reserve reported student loan balances were $1.31 trillion as of Dec. 31, 2016 — a record high level.
Planning ahead can keep you from raiding your retirement funds or over-borrowing to pay for college when the time comes. Borrowing too much can have an effect on your retirement plans and your child’s life goals. Fortunately, there are options available to parents to help them prepare for the cost of college before that happens. Here is a brief overview of some of the education funding options available:
529 Plans
529 plans are state-sponsored education savings accounts. Parents, grandparents, and others can contribute to these accounts regardless of how much they earn. The maximum that can be contributed is relatively high, currently $375,000 in New York.
These accounts allow your money to grow tax-deferred (meaning you won’t pay taxes on growth in the account). Withdrawals from the account also won’t be subject to federal tax, and in most cases, state tax, as long as withdrawals are used for qualified education expenses, such as tuition, and room and board. These accounts can be used to pay for college, vocational school, or graduate school.
If you withdraw the money for any reason besides qualified education expenses, you’ll be taxed at your current income tax rate plus incur a 10-percent penalty. If plans change, and your child doesn’t need the money for her education, you can change the beneficiary at any time to a sibling or other family member. Depending on where you live, some states, including New York, give residents a state tax deduction for contributing to the account.
UTMA, UGMA, or custodial accounts
Money contributed to a Uniform Gift to Minor’s Act or Uniform Transfer to Minor’s Act by anyone is for the benefit of your child. You can contribute to these accounts regardless of how much you earn and there is no maximum contribution limit.
When your child becomes an adult, at either 18 or 21 years old depending on each state’s law, these funds will automatically become hers and can be used for any purpose she wishes — not just for college. Earnings in these accounts are not tax deferred like 529 plans, but subject to taxes like an ordinary investment account.
However, because these accounts are owned by your child, earnings are generally taxed at the child’s (usually) lower tax rate rather than the parents’ rate.
Coverdell Education Savings Accounts
Tax treatment of Education Savings Accounts is similar to 529 accounts. Money inside this account grows tax deferred and withdrawals are not subject to tax if used for qualified education expense. The definition of qualified education expenses for these accounts includes primary and secondary schooling, not just college.
Parents who earn too much money won’t be able to contribute to these accounts. If you have a modified adjusted gross income more than $110,000 for a single person and $220,000 for a married couple, you aren’t eligible to invest in these accounts. And the maximum annual contribution amount is fairly low, only $2,000 per year for each beneficiary.
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An important issue to consider is what assets you own and what assets are owned by your child. Ownership of assets is important because it can affect your family’s ability to receive financial aid. I’ll address these issues in my next column. Before buying a 529 plan or any investment, you should inquire about the particular plan and its fees and expenses. Always consult your own tax advisor when considering investing in any of these plans.
Anthony N. Corrao is an independent advisor with Corrao Wealth Management. For more than 25 years he has helped families with their financial goals by developing financial, educational, and retirement planning strategies.
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