College Savings 101

When it comes to saving for college, typically a few options come to mind, but there's one that is not used frequently - the Roth IRA. 

How will we pay for college? Parents have lost countless hours of sleep pondering this very question - and for good reason. According to Fidelity, for the 2017-2018 tuition year, the average annual cost including tuition, fees, and room and board for a four-year, in-state public college is $20,770. For those whose children have private school aspirations, you can more than double that figure to $46,950. These annual cost figures are a wake-up call for why it is imperative to start saving for college now.

When it comes to saving for college, typically three options come to mind: 1) the Coverdell Education Savings Account; 2) UGMA/UTMA accounts; and 3) 529 plans. There is also a less frequently utilized option, but one worth considering: the Roth IRA.

The Coverdell Education Savings Account

Prior to the enactment of the Tax Cuts and Jobs Act, the Coverdell ESA had one major appeal: Coverdell assets can be used for elementary and high school as well as college expenses. With the new tax reform, 529 plan assets can be used in the same way as Coverdell ESAs, which may cause loss the Coverdell to lose some of its appeal. With an annual contribution limit of $2,000 per year per beneficiary and an inability to make contributions after the beneficiary's 18th birthday, the Coverdell seems to best suit those who limit what they contribute.

Uniform Gifts/Transfer to Minors Act Accounts

UGMA/UTMA accounts offer greater flexibility than a Coverdell ESA in that there is no contribution or age limit (although the beneficiary gets control of assets at 18 or 21 depending on the state) and assets can be used to pay for educational, as well as noneducational, expenses without penalty. In contrast to the tax-free compounding offered by a Coverdell ESA, IRS regulations state that unearned income to include investment gains in excess of $1,050 in an UGMA/UTMA account is subject to income tax. The flexibility offered by UGMA/UTMA accounts appeals to many; however, the comparatively poor tax treatment and lack of control (once the beneficiary is of age) are drawbacks that must be considered.

529 Plans

529 Plans offer many of the benefits featured in Coverdell ESA and UGMA/UTMA accounts with fewer drawbacks. A 529 savings plan is a tax-advantaged account that allows for distributions to pay for college expenses including tuition, fees, books, supplies, and room and board. As was previously referenced, beginning in 2018 distributions can also be made for elementary and high school tuition. So long as 529 plan funds are used for qualified educational purposes, there is no federal income tax on investment gains. These tax-free qualified distributions were indefinitely extended by the Pension Protection Act of 2006 suggesting this key 529 plan benefit is here to stay. 

No income or age restrictions and no annual contribution limits are additional benefits of 529 plans. Any contributions made to a 529 plan is considered a completed gift for estate tax purposes, and the five-year election option allows an individual to make a lump sum $75,000 contribution for each beneficiary and treat it as if that lump sum was contributed over a five-year period (a couple could make a $150,000 contribution per beneficiary in the same manner). This five-year election allows someone to make a large, lump sum contribution without eating into his or her lifetime gift-tax exclusion.

Each 529 plan is sponsored by a state (no residency requirement), typically in conjunction with a financial services company that manages the plan. Investments are selected from a preset menu and may be changed twice per calendar year and/or when you change beneficiaries. The state of Texas offers two types of 529 plans - prepaid and savings. Assets in the prepaid tuition plan can only be used to pay for tuition and required fees. The savings plans are more flexible, and assets can be used to pay qualified educational costs not covered by the prepaid plan to include books, lab fees, and room and board.

Extra Credit: Consider a Roth IRA

One additional college-savings option that deserves mentioning is the Roth IRA. Roth IRAs offer tax-free compounding and tax-free distributions regardless of the owner's age when the funds are used for qualified educational expenses. Contribution and income limits associated with Roth IRAs are drawbacks; however, the Roth IRA is an alternative college-savings option worthy of consideration.

Start Saving Now

Regardless of which option you choose, the most important thing is to develop a plan that works for you and your family and to start saving now. Questions? Contact your Trust Officer at 757-6300, or click here to send an email