Saving for Education: How to Manage Funds for Your Family's Future
Many of our clients want to know what they can be doing now to start planning for their children or grandchildren’s future. Since it’s important to consider future higher education costs while children are still young, here are some suggestions to get you started.
529 College Savings Plan
Probably the most popular vehicle for saving for college is the 529 savings plan. A 529 plan is an after-tax investment account that offers both flexibility and tax advantages. Typically, these plans are set up by a parent or grandparent and they are the ones who retain control. They determine how the funds are invested and make decisions on when and how the money will be used. The contribution limits are fairly high, with most states having a limit of around $300,000 per beneficiary. Only cash contributions are accepted, so stocks, bonds, or mutual funds are not an option. You are able to move your investment to another savings plan or change the beneficiary, so if your child chooses not to attend college the plan can be transferred to another beneficiary.
There are no income tax consequences for either the contributor or the designated beneficiary. When funds are withdrawn (both contributions and earnings), they are tax-free if used for qualified education expenses. If money is withdrawn for anything other than education expenses, the account owner is subject to income tax on the earnings in addition to a 10% penalty. Under the Tax Cuts and Jobs Act of 2017, 529 plan distributions can now also be used tax-free for private elementary and secondary school expenses, including public, private, and religious schools. This is effective for distributions after 2017 and the aggregate amount of distributions for these types of expenses from all 529 plans cannot exceed $10,000 per beneficiary. There is no federal deduction for contributions to the account, but many states allow either a credit or deduction. Currently, 49 states and the District of Columbia offer at least one plan option. Plans are operated by each state; however, you don’t have to contribute to your own state’s plan. You can choose any state’s plan, but be aware that some states only offer a tax deduction for contributing to your home state’s plan.
For financial aid purposes, 529 plan assets owned by the parent or student are considered parental assets on the Free Application for Federal Student Aid (FAFSA). This is more favorable, as a maximum of 5.64% of parental assets are counted on the FAFSA, compared to student assets which are counted at 20%. Assets held in a 529 account in which a grandparent (or another relative) is the owner will have no effect on the student’s FAFSA.
For those who file a Minnesota income tax return (both residents and non-residents), a non-refundable credit is available equal to the lesser of $500 or 50% of the net contributions made during the year. Contributions to non-MN plans are also eligible for the credit. The credit is phased out for individual filers with adjusted gross income (AGI) in excess of $100,000 and for joint filers with AGI in excess of $160,000. Minnesota also allows an individual income tax subtraction for contributions to a 529 plan. The maximum subtraction allowed is $3,000 for joint filers and $1,500 for all other filers. There is no phase-out of the subtraction and contributions to non-MN plans do qualify. Taxpayers may claim either the credit or the subtraction, but not both.
Coverdell Education Savings Account (Coverdell ESA)
A Coverdell ESA (formerly Education IRA) is very similar to a 529 savings plan. These accounts offer tax-free investment growth and tax-free withdrawals when spent on qualified education expenses. Qualified elementary and secondary education expenses can be withdrawn tax-free as well and include supplies, books, tutoring, equipment, and special needs services. The custodian chooses how the money is invested.
The maximum contribution is $2,000 per year per beneficiary and the beneficiary must be under age 18 or a special needs beneficiary. Joint filers with modified adjusted gross income (MAGI) of less than $190,000 ($95,000 single) can contribute up to the full amount. Contributions are fully phased out for joint filers with MAGI of $220,000 ($110,000 single). A child can be the beneficiary of both an ESA and a 529 plan. The money must be used or transferred to another beneficiary before the child turns 30.
For financial aid purposes, ESA’s owned by the parent or student are considered parental assets on the FAFSA. Assets held in an ESA in which a grandparent (or another relative) is the owner generally have no effect on the student’s FAFSA; however, some schools use slightly different formulas to calculate financial aid eligibility.
Uniform Gifts to Minors Act (UGMAs) and Uniform Transfer to Minors Act (UTMAs) are custodial accounts that allow the custodian to put money aside in trust for the benefit of a minor child or grandchild. As trustee, you are the one that controls how the money is invested and spent until the child reaches the age of majority (18 or 21 depending on where you live). Once the child attains the age of majority, he or she owns the account and can use the money how they wish. Although the intention of the account might be saving for college, ultimately, the money can be used however the beneficiary decides.
There are no contribution or income limitations. Income earned in custodial accounts is subject to income tax on the minor's income tax return. If income reaches the $2,100 threshold (for 2018), kiddie tax will be triggered and the income will be taxed at the trust rates. For financial aid purposes, these accounts are considered an asset of the child, having less favorable treatment.
Although most people think of a Roth IRA as a savings tool for retirement, it can also be an option for saving for college. Unlike other tools discussed, Roth IRA’s can be used for both college expenses and retirement income. Roth IRA's are funded with after-tax dollars and your investments grow tax-deferred. The Roth has a wide variety of investment choices and they can hold mutual funds, stocks, bonds, and options.
One drawback of the Roth IRA is the lesser contribution limits. For 2018, individuals under age 50 can contribute a maximum of $5,500 and those over age 50 can contribute a maximum of $6,500. Additionally, you cannot contribute if your MAGI exceeds $199,000 for joint filers ($135,000 single). In order to contribute, you must have earned income to do so (wages, self-employment income). This makes it more challenging for grandparents to participate as they often do not have earned income.
With a Roth IRA, you are able to withdraw up to the amount you have contributed at any time without penalties or income tax. The balance of the Roth above and beyond the amount contributed ("earnings") are typically subject to income taxes and a 10% early withdrawal penalty if taken before age 59 1/2. However, if the money withdrawn from your Roth IRA is used for qualified higher education expenses for you, your spouse, your child, or your grandchild, the penalty does not apply. If a distribution is taken before age 59 1/2, even if used for higher education, you still have to pay income tax on the earnings.
If there are funds left over in the account, or if your child decides not to attend college, the remaining funds can be used to supplement income in retirement. For FAFSA purposes, Roth IRA accounts (and other retirement accounts) are not counted as assets, so the value won't hurt the student's financial aid eligibility.
A Section 2503(c) trust is an irrevocable trust established for a minor child and managed by a trustee. It requires the drafting of a trust document which must be completed by an attorney. Only one trust beneficiary is allowed and he or she must be under the age of 21. The trustee can withdraw funds and distribute them directly to the minor child or use them to cover education expenses on behalf of the child. Once the beneficiary reaches age 21, he or she must be given the right to withdraw the assets. Any income distributed to the beneficiary will be taxed to the beneficiary which may result in kiddie tax (unearned income of the child taxed at trust tax rates). Any undistributed income held in the trust is taxed at the trust rates. For financial aid purposes, these trusts are considered an asset of the child, weighing more heavily on financial aid.
Health and Education Exclusion Trust (HEET)
A Health and Education Exclusion Trust is a multigenerational trust in which the funds are used to pay educational and medical expenses of persons two or more generations younger than the person who created the trust. The trust must also name at least one charitable beneficiary who must then receive at least 10% of the trust's income annually. A HEET makes the most sense for clients that wish to provide support to younger generations for educational and medical purposes. Any type of asset can be contributed to the trust and the trustee can decide how the funds are invested. The distributions must be paid directly to the educational institution or medical provider, and cannot be paid to an individual beneficiary. Distributions are taxable to the beneficiary to whom the distributions are made, or if undistributed, taxed at the trust level. Distributions can be used not only for higher education but for primary and secondary schooling as well. Unfortunately, these trusts are considered an asset of the child for financial aid purposes.
A Crummey Trust, named after the first taxpayer to use this type of trust successfully, is used to make gifts to beneficiaries of any age. Any time a contribution is made to the trust, the beneficiary must be given the right to withdraw the contribution during a specified time frame (typically within 30 or 60 days). The maximum withdrawal is the annual contribution, not the full value of the trust. While the beneficiary must be given the withdrawal right, withdrawals don't usually occur as the beneficiary typically realizes if they exercise that right, the donor might stop contributing to the trust. Assuming the beneficiary waives his or her right to withdraw, control over the contribution is given to the trustee. The trustee then has the right to make distributions from the trust for the benefit of the beneficiary. The beneficiary has no right to receive the property at 18 or 21, so the trust continues for as long as is specified in the trust agreement. In most cases, the beneficiary must pay the tax on the income earned by the trust. For financial aid purposes, Crummey Trusts are treated as an asset of the child and can, therefore, have a high impact on financial aid.