Getting educated: saving for your children’s college education

The American middle-class family has three major reasons to put money aside. The first is buying a starter home. The last is, as you already know, retirement. But there’s that one in the middle that often gets neglected by investors and advisors alike: your children’s college education.

The 101 on 529s

The most commonly referenced vehicle for college savings is the 529 plan, which provides a tax shield for putting money aside for education. And a lot has changed since it was first added to the Internal Revenue Code in 1996.

It wasn’t always a savings plan. In a classic example of states acting as laboratories for federal policy, Michigan began allowing its residents to prepay their kids’ tuition at public institutions starting in 1986. The immediate effect was that the tuition bill for future members of the Michigan State Class of 2007 could be no more than that of their older cousin who still wore a Members Only jacket. Considering that tuition inflation is historically more than double that of consumer price inflation, this was an incredibly good deal.

It took more than a decade to sort out, but Michigan was able to persuade the IRS that its education trust could invest the prepaid tuition tax-free in order to make it viable; more correctly, it persuaded an appellate court to persuade the IRS. Today, there are 10 states that offer prepaid tuition plans and are accepting new applicants:

  • Florida
  • Illinois
  • Maryland
  • Massachusetts
  • Michigan
  • Nevada
  • Pennsylvania
  • Texas
  • Virginia
  • Washington

Once the law was settled, it became clear that the difference between what the parent prepaid for tuition in the 1980s and what its market value would be in the 2000s constituted income. The question switched to whether that income ought to be tax-exempt or be tax-deferred. After some political tussling, the tax-exempt advocates won. That means the donor can’t write off contributions in the year they are made, but they won’t be taxed when they are withdrawn for qualified expenses.

Once that was established, it opened the door to 529 savings plans. Rather than prepaying tuition, parents could invest in a vehicle similar to a retirement account, perhaps grow the money faster than colleges can raise their tuition, then pay education costs tax-free.

And that led to the question of what constitutes qualified college costs. Tuition, sure, as well as dorm rooms, meal plans, and textbooks. But it took some time for off-campus housing and groceries to be accepted. It wasn’t until 2011 that computers were undisputedly covered. Student loan interest and debt are specifically denied as educational expenses.

While 529s continue to be administered by each state, the national standard for tax treatment enabled students and their parents to pick whatever school they chose. It no longer had to be their home state’s university. In fact, it neither had to be within that home state nor a public school. It could be an accredited university, college, or vocational school, as long as the beneficiary is at least a half-time student. You can even invest through any state’s 529 plan – it doesn’t have to be the one offered by the state you live in or where your kid plans to go to school.

And, as a result of the 2017 tax law, 529 savings can also be spent on K-12 education at public, private or parochial schools. Those who choose to home-school their children do miss out on this benefit.

Today, 529 savings plans might be state-sponsored, but they are professionally managed and generally invested in mutual funds rather than individual securities. In this tight labor market, some employers have started matching employees’ 529 contributions.

NerdWallet presents a couple of tables that compare each state’s 529 prepaid tuition and savings plans. It does not compare their historical returns or their fees. For that kind of information, consider contacting your financial advisor.

Advanced seminar

On a related note ABLE accounts, also called 529As, allow Americans with disabilities to put aside additional funds for education, per the Achieving a Better Life Experience Act of 2014. Prior to that, disabled people faced disincentives to saving for post-secondary education, up to and including loss of eligibility for government benefits. ABLE accounts allow their beneficiaries attending school to spend on expenses related to their disabilities without putting other benefits at risk, having their parents go through the expense of putting together a trust fund or simply living below the poverty line.

As part of the 2017 tax law, 529 funds can now be rolled over into ABLE accounts.

But there are other ways to save for your children’s education that are unrelated to 529s. One is the Coverdell Education Savings Account, also called an ESA or an education IRA. The advantage to ESAs is that you can invest in pretty much anything, unlike the 529 approach that limits you to selecting among mutual funds. As with 529s, the 2017 tax law allows ESAs to be used for K-12 expenses. There are income limits. You can only contribute up to $2,000 per year, so an ESA isn’t always the best basket for all your college savings eggs.

But UTMA and UGMA funds can be used for educational purposes. Ditto for Roth IRAs; even though the “R” stands for retirement, withdrawals can be made for qualified educational expenses.  This gets tricky, however.  Qualified education expenses could help you avoid early withdrawal penalties if you are under 59.5 but income tax may still be due on earnings.  Distribute at your own risk!

Homework

A recent study found that only 29% of taxpayers have even heard of 529s and know what they are for. For comparison’s sake 32% not only know about 401(k) retirement plans but also put money into them every paycheck. And that 32% figure is itself nothing to brag about.

It gets worse. Fewer than half of all American parents are saving for their children’s education, and the average balance in a 529 is barely $18,000 and wouldn’t cover a year at a state college.

That’s why the states – and the professional money managers that run their 529 savings plans – are competing for investment dollars from plan-ahead thinkers like you, and state-by-state differences abound. Depending on where you live, there might be state tax benefits to keep you from straying. And there might also be tax disadvantages to paying all college costs out of the 529 rather than partially out of current income. Also, because 529s remain the property of the donor but are not included for estate tax purposes, they can be used for estate planning purposes – presuming you’re doing estate planning. But that’s an entirely different topic. It gets complicated, and perhaps you should discuss your goals and options with your financial professional.

Although there are different ways to save for your children’s education, the important thing is that you do so. Start now, even if you just put a few bucks a week into a generic savings account or parking some cash in Treasury bonds. You can roll it over into a more optimal vehicle after you and your advisor have determined what that is.