Stay True to Your School (Savings Plan)

Saving for college rivals saving for retirement as a priority for many parents.  And for good reason.  A college education is now a prerequisite for entry into American middle and upper socioeconomic classes, and as more and more students choose to apply to college, the costs intendant to higher education increase. 

These costs include not only the cost of college tuition, but also expenses associated with improving a student’s likelihood of being accepted into the college of their choice, such as private secondary school tuition, the cost of tutoring to maintain a competitive grade point average, fees for ACT and SAT prep courses and expenses relating to extracurricular activities.

Fortunately, there are some strategies that can help parents save for college while minimizing taxes.

529 Plans

529 plans are state-sponsored investment plans that are authorized by Section 529 of the Internal Revenue Code.  While these plans vary by state, there are two general types: (1) pre-paid tuition plans and (2) education savings plan. 

Pre-paid tuition plans allow parents to purchase credits at participating colleges and universities for future tuition at the current tuition rate.  Given that the cost of tuition increases at an estimated 8% per year, the cost savings of pre-paid tuition plans can be significant.  However, pre-paid tuition plans cannot be used to pay for future room and board and cannot be used to pay for tuition for elementary and secondary schools.  Furthermore, if the child chooses to attend a college that is not “participating,” the pre-paid tuition plan may only pay a small return on the original investment.

Education savings plans allow parents to invest money for future educational expenditures, with any interest earned by the plan being exempt from federal income tax (and sometimes state income tax, depending on the state) as long as the funds are used for a qualified education expense.    

Qualified education expenses are limited to college tuition, room and board, books and school supplies and technology items (computers, printers, internet service).  Secondary school tuition (up to $10,000 per year) is also a qualified education expense, but not room and board, books and school supplies or technology items relating to secondary school attendance.

In addition to the benefits of tax-deductible contributions and tax-free growth, section 529 allows a grantor to fund an education savings plan with an amount equal to five years of the annual exclusion amount without incurring gift tax – meaning that parents can front load these plans with up to $75,000 in a given year (although they would not be able to make additional contributions to the plan or the beneficiary for 5 years without incurring gift tax).  This feature of section 529 is potentially very valuable from an income tax perspective, particularly in those states that also offer an income tax deduction on 529 contributions (such as New York).  Moreover, education savings plans also allow the owner to change the beneficiary of the plan, enabling parents to maintain the tax benefits of the plan in the event that the initial beneficiary decides not to attend college.     

However, there are some pitfalls to education savings plans.  For example, if a withdrawal is made for a non-qualified expense, the owner of the plan will be liable for paying federal (and possibly state) income tax on the withdrawal, plus a 10% penalty.  As a result, parents should be sure that they are investing only what they can afford to set aside for educational expenses, because dipping into the plan for other expenses can be costly.  Furthermore, the appeal of education savings plans is greater in some states than in others.  For example, in New York, contributions to these plans are tax-deductible while in other states, such as New Jersey, they are not.

Annual and Lifetime Gifting

In addition to 529 plans, educational savings can be achieved through traditional gifting.  Minimalism (thank you, Marie Kondo) and the environmental consciousness of consumerism are becoming the trend in many households and, in an effort to reduce the amount of “stuff” in their homes, parents are now asking loved ones to give experiences – rather than possessions – to their children in celebration of birthdays and holidays.  These “experiential gifts” often include pre-paying for swimming lessons or music lessons or summer Lego camp – all things that will benefit children in their lives and, potentially, on their college applications.

Currently, individuals can make annual gifts of up to $15,000 per person ($30,000 for married couples) and lifetime gifts of up to $11.2 million ($22.4 million for married couples) without incurring gift tax.  Furthermore, individuals can make unlimited “qualified transfers” that do not diminish one’s annual or lifetime exclusion amount.  “Qualified transfers” are direct payments for tuition; for example, writing a tuition check directly to a university – even if it is in excess of $15,000 – is not a taxable gift and will not reduce one’s ability to make gifts of $11.2 million gift-tax-free during one’s lifetime.

Gifting can be structured to take advantage of both the annual exclusion and/or lifetime exclusion, as well as the rules relating to qualified transfers: one can use qualified transfers to directly pay for tuition, and annual exclusion gifts to pay other educational expenses or to fund education trusts (discussed below).  Even if this structure is not tenable for parents, it may be attractive to wealthy grandparents because it doubles as an estate planning technique – by transferring assets during one’s life, one reduces, or even eliminates altogether, the estate taxes due upon one’s death.

Education Trusts

Education trusts are an alternative to 529 plans. Annual exclusion gifts that otherwise would have been utilized on 529 plan contributions can be used to make contributions to an irrevocable trust for the benefit of the child, which can be structured to allow for more flexibility than a 529 plan.

Some of the advantages of an education trust over a 529 plan are:

  • Trust assets may be invested in a wide array of investments, instead of the limited options of a 529 plan

  • Trust documents can provide flexibility that allows trustees to distribute assets for “non-qualified” educational expenses, as well as for other purposes, including medical expenses, support and maintenance

  • Assets can remain in trust for the benefit of beneficiaries even after education is completed, offering a level of asset protection from creditors, ex-spouses and spendthrift beneficiaries

  • Trusts can hold life insurance as well as a beneficiary’s interests in other family wealth transfer vehicles (such as family limited partnerships)

Despite these advantages, education trusts do not provide income tax benefits.  The estate tax benefits of using trusts (and paying tuition and other education expenses directly) must be weighed against the loss of the income tax benefits of a 529 plan, as well as the legal and compliance costs associated with employing trusts.

At the end of the day, there are many options for parents interested in saving for college – it’s just a matter of finding the right fit for your family and your finances.