Everything You Need to Know About College Savings

When my children were born, my first concerns were about their health, my new sleep patterns, and then funding for their college education.

Many of us expect that our children will grow up to be successful individuals and expect them to attend college on that road to success.

A child’s journey through K-12 schooling will typically be an easy path to follow, because your town or city provides public education. This route may veer a bit if the school district’s offering is not satisfactory and you decide to move to an area on par with your standards, or you opt for private school.

Whichever choice you make, if higher education is a goal, you’ll need to consider the cost. Certain types of post-secondary education options can cost as much as a home, for each child, so it’s prudent to start saving as soon as your child is born.

Let’s consider the target amount of funding. As an example, both of my sons attend private universities at a current cost of approximately $80K per year per student. The current 4-year private university tuition inflation rate is approximately 3.5%[1], therefore, in 17 years a 4-year degree is expected to cost approximately $625K for one student.

Is this the target saving level to attain by 2041? How do I achieve the target amount? Do I invest as much as I can, now, or do I contribute annually to the savings vehicle of my choosing?

When I considered my saving options, I was overwhelmed. What is the correct path forward? I received unsolicited advice from friends, family, etc. Rest assured, there is no single, all-encompassing, correct answer to funding your child(ren)’s education. There are many aspects to contemplate, and once you’ve identified those factors, there remains no correct answer or strategy.

Let’s dive in and uncover the alternatives:

College Savings Vehicles

Currently, there are a few options to address college savings (most of these are designed to shield your earnings from tax liabilities if used for educational, or other intended, purposes):

• 529 Plans

• Government Savings Bonds (EE and I series)

• Roth IRA

• Standard investment accounts/options via a taxable portfolio (not shielded from taxes)

You may ask, what makes one option preferable to another? The answer usually involves a tradeoff between tax efficiency and flexibility. Another significant consideration, especially for wealthy individuals, include Estate and Gifting taxes, more on this later.

529 Plans

A 529 plan is a tax-advantaged savings plan designed to help pay for education. They are state sponsored, and each state may have their own plan. Each has its own limits per beneficiary (e.g., your child) and each has different rules, investment returns, portfolio manager, etc. I live in New York, and I used New York’s 529 for my children, primarily because my state excludes your contribution, up to $10K per year, from New York income taxes. If you don’t use the earnings for educational purposes, you will be penalized (i.e., 10% penalty in addition to an income tax liability). 529s are managed to produce a market return (think S&P 500, et al.) based on different risk options, chosen by you, provided by the portfolio manager.

Government Savings Bonds (EE and I series)

The IRS excludes interest earned on certain savings bonds (series EE and I) when used for educational purposes. The rules do change at times—generally a good and safe investment (the repayments are practically guaranteed)—although their earnings protentional are not as high as the equities and bonds market in which 529s may be invested. Also, if you do not use the earnings for educational purposes there is no penalty, and the federal government (IRS) will tax the earnings (states will not). I have also used I series bonds to save for college. This was my strategy to diversify my holdings between high-risk market exposure and low risk government investments.

Roth IRA

A little-known fact is that you can use Roth IRA investments for educational purposes, however, you should confirm the rules with your broker at the time you consider withdrawing funds. Roth IRAs are retirement vehicles with their own annual contribution limits. Unlike traditional IRAs, your contribution to a Roth IRA is made with post-tax dollars (i.e., you cannot deduct your contributions to a Roth IRA on the year of contribution). Also, unlike traditional IRAs, the earnings on Roth IRAs are tax free when withdrawn versus traditional where distributions are fully taxable. We recommend against using Roth IRAs for educational purposes unless you have a satisfactory retirement nest egg.

Standard investment accounts/options via a taxable portfolio (not shielded from taxes)

The standard investment option is basically using your current funds (investment accounts, bank accounts, etc.) to pay for your child’s education. This is not a tax-advantaged plan. It has no limitations on where/when/how you invest while also having no penalties.

Target Amount

As mentioned above, a private university is expected to cost (based on historical inflation rates) approximately $625K for each child in 17 years. Does this mean we need to use that as a target? If you want to be able to cover the most expensive school for each child, then you’ll need to target this value, however many children don’t go to a private college and pay the full fee.

In short, save what you can and do it wisely. Prudently take advantage of the tax-advantaged options. Essentially, you don’t need to put all your eggs in one basket, like 529 plans. Invest more sooner than later to benefit from investment compounding. A dollar invested today will be worth more in 20 years than investing a nickel each year for the next 20 years.

Estate and Gifting Taxes

As mentioned earlier, there are potential limitations to how much you can place into an education savings vehicle. The primary concern is the beneficiary of this vehicle. If you are setting up a 529 for your child as the beneficiary, any contribution to them will be considered a gift. Why is this important? Gifting limits are set by the IRS annually—these are the amounts you may give to someone, any individual, annually, without reporting the value of the gift. This gift limitation originates from the estate tax rules, whereby there exists an exemption limit below which you would not be liable for estate taxes upon your death. You will be taxed on your estate, if your estate is greater than $13MM, you may not gift more than $13MM during your lifetime to evade the estate tax. Therefore, any gift more than the gift exclusion, currently $17K per year per person, will eat into the $13MM exemption level and must be reported to the IRS so they can keep track of your utilization of the exemption. In practical terms, if you are never going to grow your estate beyond $13MM, then the only detriment to gifting more than $17K is that you must report the gift. In this case, funding a 529 with $50K each year over the next 5 years could potentially achieve the education goal if you achieve a 6% return per year over 18 years. You will need to report the excess $33K per year ($50K - $17K) as gifted to your child.

I personally utilized 529 accounts and government bonds, the latter for simply maintaining some additional diversification to the level of approximately 80% of the expected cost. The remaining expense will be paid from my taxable accounts. If my children had attended a state university, I may have been overfunded, and I could have used the excess funds to pay for post-graduate and/or other family members’ continuing education. Also, I would have used the 529 funds and kept the government bonds as an investment, as they would not incur a penalty if not used for education.

There is no single right answer about how to save for higher education expenses. It depends on the particulars of your financial situation, and the tradeoffs you want to make with regards to taxes and flexibility. At Ahara Advisors, we guide our clients through these tradeoffs, and provide options that are consistent with their aspirations.

[1] CNBC