Beyond paying out of cash flow or using an inheritance, high-income earners (and even more-moderate- income people) can save for college in various ways. Here are seven of the most common techniques to advise your clients of, some of which they may not have considered when thinking about college savings.
1. 529 college savings programs
529 plans continue to grow in popularity. Named for Sec. 529, the plans do not allow tax-deductible contributions, but contributions grow tax-deferred. Distributions are income tax-free when used for qualified education expenses.
What is good: There are no limitations on the participant/contributor's income, so anyone can open one. There are income tax advantages of tax-free distributions for qualified education expenses, and the account is outside the owner's estate for estate planning purposes. Contributions are subject to gift tax, however, so participants may want to keep the amount of money they contribute below the annual exclusion amount. There are no federal limits to account balances, but different states have different limits, which are important to know when setting up accounts.
What is not: Investment choices are limited; only two changes in account allocations are permitted each year, and some plans are costly because they charge high management fees.
Planner's tip: It pays to shop around—costs and investment choices are key. Participants do not have to choose the plan in their state, but state tax advantages are usually unavailable if they do not.
2. Prepaid or "private" 529s
Prepaid or private 529 accounts have the same tax characteristics as regular 529 plans mentioned above, but the growth in the account is guaranteed to at least match tuition increases at select schools.
What is good: They have the same tax benefits of state 529 programs plus a guarantee of keeping pace with tuition if the beneficiary uses an approved college.
What is not: School selection is limited and consists mostly of in-state schools. Some "private" 529 plans have over 300 participating schools, however.
Planner's tip: Participants can always use the prepaid plan at any school, though there is no guarantee on growth unless the beneficiary uses a participating school. Participants can also transfer a regular 529 into a prepaid 529 plan once they have a better idea of which school their child is going to. These plans are beneficial because they guarantee the account balance keeps up with the school's tuition. But some restrictions may apply, for instance, the account must be open for three years to participate in the guaranteed tuition increases
3. Custodial accounts or Uniform Transfer to Minors Accounts (UTMA)/Uniform Gifts to Minors Accounts (UGMA)
UTMA/UGMA accounts have similar limitations as 529s (being subject to gift tax) but fewer income tax advantages. The income on these accounts is taxed to the owner.
What is good: Although there are some tax benefits, there may be issues with the kiddie tax, which taxes children's unearned income at their parents' rate if it exceeds certain thresholds. The accounts permit more control of investments and usually have lower fees than 529 accounts.
What is not: The custodian loses control of the account when the child reaches the age of majority. That can be a major concern as these accounts grow large.
Planner's tip: These accounts are more flexible than 529 accounts. For example, the child is not required to use the funds for college but can instead use it for a down payment on a house or another purchase that the child may want to make. Also, there is more investment control because the participant/contributor can invest the money anywhere—not just in the fund chosen by the plan, like a 529. Finally, for non-U.S. citizens who may go back to their home country, they are not locked in to using a certain school in the United States—to be a qualified school for 529 purposes, it has to have a code for federal financial aid.
4. Coverdell or Education IRA
Most high-income earners are not eligible for a Coverdell account, due to the income restrictions, which phase out between $190,000 and $220,000 of adjusted gross income (AGI) for joint filers. However, they can always fund a custodial account and then encourage their child to use this money to fund the Coverdell account. Contributions are limited to $2,000 a year per child.
What is good: They have the same tax benefits as a 529. A big advantage over a 529 account is that a child can use the funds for expenses other than college, e.g., tuition at a private high school, transportation, school uniforms, or computers.
What is not: They have income limitations and an annual contribution limit of $2,000 per child.
Planner's tip: The Coverdell is a nice way to save for tuition at a private high school, except for the income limitation. One possible solution to the income limitation is to have the parent contribute to the UTMA and having the UTMA contribute to the Coverdell—so long as the Coverdell account owner can meet the income restriction, which in this case should not be a problem since it is the child.
5. Roth IRA
Generally speaking, high-income earners won't qualify to contribute directly to a Roth IRA. However, if children have earned income, they can contribute to a Roth IRA, subject to certain limitations. A high-income earner can always contribute after-tax money to a 401(k), then, after terminating employment, transfer the after-tax portion of the contributions to a Roth IRA.
What is good: The portion of a Roth IRA used for qualified education expenses is exempt from the 10% early withdrawal penalty. If withdrawals are limited to contributions, the distribution is tax- and penalty-free if used for qualified education expenses. An additional advantage is there is more control over investments and costs in a Roth IRA.
What is not: The Roth IRA has low annual contribution limits ($5,500 annually, $6,500 for those over 50 years old) and income limitations (phase out at AGI between $184,000 and $194,000 if married filing jointly).
Planner's tip: Children can get summer jobs and contribute to their own Roth IRAs, if not for college, then for their own retirement.
6. Whole life insurance
Whole life insurance has no income limitations and no contribution limits, and it allows for income tax-free accumulation of cash value and income-tax-free distributions via a loan for any reason at any age. (The death benefit is reduced by any outstanding loan.)
What is good: It covers the need for life insurance if there is one and creates options—the owner of the policy can use the cash value for college or retirement.
What is not: Cash value growth may not keep up with the rising cost of tuition. In addition, the cost for the policy is usually greatest in the early years of the investment, which is not good for students closer to college.
Planner's tip: High-net-worth parents can purchase a policy on their child's life, buying more benefit than if they bought one themselves.
7. Deferred compensation
High-income earners with access to deferred compensation can structure the payouts to coincide with college tuition payments.
What is good: Contributions are made pretax, and earnings are tax-deferred. These plans can also help manage cash flow.
What is not: The deferred compensation account is an unsecured creditor of the employer.
Planner's tip: It's best not to overfund the retirement account because of the unsecured creditor issue, but the taxpayer will have to defer long enough to make up for the ordinary income tax on the distribution. Also, payments from nonqualified deferred compensation arrangements must meet certain tests under Sec. 409A in order to avoid being included in income. These include requirements for distributions, acceleration of benefits, and elections. Plan failure will result in federal taxation of income deferred under the plan for that year and all preceding tax years (to the extent it is not subject to a substantial risk of forfeiture and was not previously included in income) and may also result in taxation by the state where the income was originally earned.
Planning for college involves many choices and trade-offs. Many other factors also must be considered, including financial aid implications and parents' own retirement funding. Are the parents saving enough for themselves?
Only a well-thought-out comprehensive plan can help clients accomplish multiple financial goals.
Michael J. Aloi is a certified financial planner at Summit Financial Resources Inc. who specializes in retirement planning, income tax strategies for executives, asset allocation and portfolio advice, and restricted stock and deferred compensation strategies.
Michael Aloi is a registered representative with Summit Equities, Inc. Securities, and investment advisory services are offered through Summit Equities, Inc. Member FINRA/SIPC. Financial planning services are offered through Summit Financial Resources, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666.
Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. If you require specific tax advice, please consult a qualified tax professional.
Recommendations expressed may not be suitable for all individuals. You should not rely exclusively on the information in this presentation. Independent research of the risks involved should be conducted. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.