Benjamin Franklin famously said in 1789, “…in this world nothing can be said to be certain, except death and taxes.” We believe this famous phrase should be changed to include “the rising cost of education.” According to CollegeBoard.org, between the 2011-12 and 2016-17 school years, published tuition and fee prices rose by 9% in the public four-year sector, by 11% at public two-year colleges, and by 13% at private nonprofit four-year institutions, after adjusting for inflation! With those increases, the average annual cost for the 2016/2017 college year, at a four-year college for in-state students was $24,610, while the average cost for out-out-state students was $39,890.*
With the cost of college education rising year-after-year, it is no surprise saving for a child’s college education is top-of-mind for most parents. While it is prudent to start putting money aside for college as early as possible, the question becomes, “Where is the best place to save for this?” The statistics noted above may seem like an overwhelming price tag, especially if you are saving for college at the same time you are saving for your own retirement, but there are several investment vehicles and options that you can utilize to help fund this cost for your child. Each have their own advantages and disadvantages, along with various features, such as tax advantages, income thresholds, or even penalties if the money is not used for college-related expenses.
Here are the 3 best college saving options that you should know.
1. 529 Plans: State Savings Plans
Arguably the most popular savings vehicle for college, the 529 state savings plan offers investors the opportunity to save money for college in individual investment accounts that are tax-advantaged. While the details vary state-to-state, the fundamentals of these plans are identical. To open an account, simply fill out an application and name the beneficiary (i.e. your child/student), then choose one of the plan’s investment portfolios for your contributions. Your contributions in the 529 state savings plan can be as frequent as you like and equal to any dollar amount, subject to plan limitations.
“Enrollment Based Portfolios” allow you to invest in a diversified portfolio, typically corresponding with the year your child will start college and become more conservative as the student gets closer to attending college. Most plans also offer fixed portfolios that range from aggressive, equity-based accounts to conservative, fixed-income funds. It is important to discuss with your financial advisor the most appropriate investment allocation given the age of the child, your risk tolerance, and the investment options available. Keep in mind the 529 account may gain or lose money, and there may be fees associated with opening and maintaining an account.
One of the main advantages of the 529 state savings plan is that all of your contributions grow tax-deferred. In other words, you do not pay any income tax on the account’s earnings each year! It is also noteworthy that some states, including Maryland, offer a state-income tax deduction for your contributions. In Maryland, for example, you may deduct up to $2,500 of contributions each year from your Maryland State income per beneficiary, per contributor.
When it comes time to withdraw your money for qualified college expenses, the earnings are federally tax-free and may also be tax-free at the state level. On the other hand, if the money is not used for college-education-related expenses, known as a non-qualified withdrawal, you may be subject to a 10% penalty on the earnings of the withdrawal, as well as ordinary income tax.
A unique feature of this 529 Plan is that if your child does not elect to go to college, the account can be transferred to a qualified family member, such as a sibling, without incurring any penalties. Also, if you are not satisfied with your current plan, you have the eligibility to roll over your account to a different 529 plan with another institution. It is important to note though that this can only be done once every 12 months.
2. 529 Plans: Pre-Paid Tuition Plans
Even though a pre-paid tuition plan is also a tax-advantaged college savings plan, the two are quite different. The pre-paid tuition plans allow parents, grandparents, and others to pre-pay tuition and any required fees at today’s rates at any qualifying public and/or private college. By pre-paying tuition at today’s cost, you are helping mitigate any future tuition cost increases. In addition to state-run plans for public schools, private colleges and universities also have pre-paid plans.
Opening an account and naming the beneficiary is the same as the 529 state savings plan, but how you contribute and invest differs greatly. You, a family member, or even a close friend can purchase an amount of tuition, in either years or credits, in one lump sum or through periodic payments. Normally, the tuition credits are guaranteed to be worth a certain dollar amount or a parentage of tuition costs, regardless of how much tuition increases over time. Your contributions are then pooled with other account owners in a general fund to be invested. Ideally, the plan hopes to earn a return greater or equal to the college tuition inflation rate.
Just like the 529 state savings plan, your earnings grow tax-deferred, and some states, but not the federal government, also allow you to deduct your contributions from your state income tax, up to a specified amount.
The biggest advantage of the pre-paid plan is the safety of the investment. Regardless of how the market performs, you are guaranteed to receive a return equal to the rising cost of education. Sure, taking market volatility out of the equation is great, but there are drawbacks to consider. One disadvantage is that only tuition and mandatory fees are covered. Therefore, you may have to consider another vehicle to save for room and board and other expenses. The major shortcoming is: funds invested in a state-run pre-paid plan can only be used at full value to pay for tuition and fees at in-state public colleges. Likewise, funds invested in a private college 529 can only be used for member colleges. If the child attends an out-of-state public school or a non-member private school, there may be limitations and/or the potential for a loss of earnings.
3. Coverdell Education Savings Accounts (ESA)
A Coverdell ESA is tax-advantaged education savings account established for a child under the age of 18. The child does not need to be your dependent, and contributions can total up to $2,000 each year. These accounts can help save for college, as well as any elementary or secondary education at public or private schools.
As long as the withdrawals are for qualifying education expenses, such as tuition, fees, books, or supplies, the earnings are tax-exempt. Also, you have more investment options, such as stocks, bonds, mutual funds, or even certificate of deposits (CDs).
Not everyone can open a Coverdell ESA, however. Your ability to contribute is dependent on your household income. If your modified adjusted gross income (MAGI) is less than $95,000 for single tax filers, or less than $190,000 for joint filers, you can make a full $2,000 contribution per year into a Coverdell ESA. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000 and joint filers with a MAGI between $190,000 and $220,000.
As with any important financial decision in your life, please discuss your unique situation with your financial advisor to determine which option is right for you and your family.
*College Board’s 2016 Trends in College Pricing Report
The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that a college-funding goal will be met. In order to be federally tax-free, earnings must be used to pay for qualified higher education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10-percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.