A Crash Course in College Cache

By Jason Silverberg, CFP^®, CLU^®, ChFC^®

Back to school time is the time of year where parents scramble around gathering up school supplies, adorning their children with new outfits, and accessorizing their ensembles with cell phones and other electronic gadgets. With all of this spending, let’s think a bit about saving to balance everything out, specifically for college. Here are 4 ways in which you can start saving for college.

Custodial Bank Account

These accounts also go by Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) accounts. They can be traditional savings accounts held at the bank or can be mutual funds or similar investments held with a broker. In either case the parent or guardian is the custodian on behalf of the minor child, with the account registered under the child’s social security number.

The two main reasons people choose this option is convenience and taxation. It is convenient because the banks traditionally have low minimums for these accounts and make them very easy to establish. Additionally, they are helpful for the parent because it makes it easy to segregate each child’s funds. From a tax perspective it is assumed that the child is in a lower bracket and therefore keeping it under the child’s social security number has tax benefits.

While these accounts are the most common, the reality is they are not always the best option for college savings. When the child reaches the age of majority, the money becomes theirs to do with it whatever they choose. While there is some tax favorability by having the account in the child’s name, it is still a fully taxable account.

The “kiddie tax” rules limit the amount a child can earn as passive income under their tax bracket prior to age 19 and thus the income often ends up reverting back to the parent’s tax return anyway. Finally, these accounts are deemed to hold the child’s money and thus having a significantly greater impact on any potential financial aid. UGMAs/UTMAs are not typically recommended for college savings, but are ideal for small savings accounts to teach your child about money.

Coverdell Accounts

Also called Educational Savings Accounts (ESAs) or Educational IRAs. These accounts are made for educational savings and are packaged with some interesting features. One of these features is that the money can grow tax deferred, eliminating the need to pay taxes each year. Also, if the money is withdrawn for private school or college expenses, it can be accessed tax-free, paying no taxes on any growth.

Additionally, the money is held in the parent’s name for the benefit of the child, so the parent can control how the money is spent and the child has a better chance at financial aid qualification. One additional advantage of the ESA is that funds may also be available private schooling prior to college as well for college. Keep in mind, there is a maximum contribution limit of $2,000 per year, as well as restrictions based on the income level of the donor, so it may be hard to accumulate lots of funds for college in this vehicle.

529 Plans

A 529 plan is a tax-advantaged investment program designed to help pay for qualified higher education costs. Being one of the most popular ways to save for college, the 529 plan comes in two flavors: prepaid tuition plans (only offered in select states) and savings plans.

With prepaid plans, you can purchase tuition at today’s rates instead of the inflated rates when your child is ready to go to school. There are some dangers in doing this. For one, the money is considered to be the child’s resource and does reduce the chances of financial aid. Furthermore, if the child doesn’t go to college, you may or may not be able to transfer your credits to another child, depending on your resident state.

With a savings plan, the investment risk and contribution commitments shift to you. Participation in a 529 plan does not guarantee that the contributions and investment returns will be adequate to cover higher education expenses. Contributors to the plan assume all investment risk, including the potential for loss of principal, and any penalties for non-educational withdrawals. 

If you need flexibility in the amount of contributions or if you feel that you may be able to get a higher rate of return to beat out tuition inflation, this may be the account for you. These accounts are similar to ESAs, but must be used for college expenses only to be able to withdraw the money tax free. If withdrawn for other expenses, you’ll be taxed and penalized on any growth. Also, these accounts are transferable, allowing you to transfer the account to other children (must be a relative), if one gets a scholarship or decides not to go to school altogether.

One other important difference with the ESA is that the max contribution to the 529 plan is much higher. Since contributions to a 529 plan are considered gifts, the limit maxes out at $14,000 per year (Per Parent, Per Child in 2017) or a lump sum of $70,000 (representing contributions for the first 5 years).

529 plans are generally state-sponsored, enabling state tax deductions on eligible contributions for partnering with a fund company represented by the state in which you reside. Your state of residence may offer state tax advantages to residents who participate in the in-state plan. You may miss out on certain state tax advantages should you choose another state's 529 plan. Consult with a financial advisor to learn more about how state-based benefits or limitations would apply to your specific circumstances.

Life Insurance

So, the 529 plan sounds good, but what if you only have one child who may or may not go to college, or if you think they may receive a scholarship? How can you save for college effectively with these concerns?

Cash value life insurance may be your answer. Remember that the primary reason for purchasing life insurance is the death benefit. At the same time, the growth of cash value is tax deferred and money can be withdrawn tax favorably, with one major exception. There is no need to prove that you are using the money for qualified educational expenses to be eligible for tax favorable withdrawals. Outstanding loans and withdrawals will reduce both cash value and death benefit. Policy loans and withdrawals may create an adverse tax result in the event of a lapse or policy surrender, and will reduce both the cash value and death benefit.

Using cash value life insurance may not be for everyone. If you do not otherwise need or want life insurance, there are insurance expenses and possible restrictions, such as surrender charges, that can get in the way of accumulation. At the same time, if life insurance is needed, costs can be minimized by combining the two objectives into one savings vehicle.

No matter the vehicle, it is vitally important that you start early. A $100 per month contribution in a tax deferred vehicle will yield about $54,000 in 18 years at a 9% rate of return. If you waited just 2 years and invested for 16 years, you’d have only about $43,000. That’s a difference of $11,000 or about 20% of the portfolio. This is a hypothetical example for illustrative purposes only and is no guarantee of performance.

While this sounds well and good, don’t get too carried away. Many parents tend to put their children first and save for college before, or as an alternative to, their own retirement savings. This is a big financial “no-no.” You can always take out loans for college, but you can’t take out loans for retirement. Consult your financial advisor for more information on how to customize a college savings strategy that fits your budget, without compromising your other financial goals. Finally, please keep in mind that you should check with your individual tax advisor on the tax benefits or impact to your specific situation. 

In my book, The Financial Planning Puzzle, , I discuss these items and other investing strategies. You’ll find this and a lot more valuable information as your fitting your financial pieces together. Buy the book now on Amazon.com here.

If you’d like to discuss your own personal finances, you can email me directly at jason@finadvinc.com or call me at 301-610-0071.

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Jason Silverberg CFP®, CLU®, ChFC®, specializes in compressive financial planning. His practice aims at helping families and small business owners to fit their financial pieces together to create financial freedom. He uses a values-based process to connect with his clients on a deeper level than some advisors, diving into the why behind the numbers. He focuses on helping clients achieve and protect their goals through methodical investment strategies, calculated risk management, and insurance solutions. Jason is a registered representative and investment advisor representative of Securian Financial Services, Inc. Member FINRA/SIPC. Financial Advantage Associates is independently owned and operated. Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender charges.

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