College Planning for Your Children (and Grandchildren)

It is never too early to begin planning for college and considering your saving options for your loved ones—in fact, the earlier the better.

At Sylvan Financial Advisors we know you would do almost anything for your kids—we feel the same. Sending your kids to college may be one of the top priorities on your list. According to a study a few years ago by HSBC Group, 98% of US parents are considering a college education for their child, and how to fund that education is top of mind for many of them. The majority—60%—of parents would be willing to go into debt to fund their child’s college education.

The trouble is, college debt is extremely high—currently up to $1.64 trillion in America, with $1.515 trillion held by the federal government. The average student loan debt amount is now $35,397 according to the most recent data from December 2019 per the Department of Education.

Why is it so high? Well, for one thing, the average in-state tuition and fee price at public four-year institutions is $10,440 in 2019-20—per semester. That is about three times as high as it was in 1989-90, according to the College Board.

So, what is a loving parent or relative to do? For one thing, start saving now. Here are some of your options.

529 Plans

A 529 plan, technically known as a “qualified tuition program” under Section 529 of the Internal Revenue Code, is an education savings plan offered by all 50 states and the District of Columbia. There are generally two types—prepaid tuition which allows you to lock in today’s tuition rates for the future college attendee, and the more popular 529 savings plan.

Keep in mind that you aren’t restricted to your own state’s plan. You can invest funds in any state’s plan, and your student can attend college in any state. Each state’s 529 plan is unique, with a different combination of sales channels, investment offerings and fees—including loads for broker-sold plans, enrollment fees, annual maintenance fees and asset management fees. Because of this, it pays to shop around when choosing a plan because even if your state offers a tax deduction or credit for contributing to your state’s plan, that benefit might not stack up against the performance or lower cost of another state’s plan.

Pros of 529 Plans

Although contributions to a 529 plan aren’t tax deductible on your federal tax return, the earnings grow tax-free when withdrawn and used for qualified education expenses. (Qualified education expenses include college tuition, room and board fees, or textbooks. And as of passage of the Tax Cuts and Jobs Act of 2017, also allowed are up to $10,000 per year for K-12 education expenses such as private school tuition or tutoring.)

Many states offer state income tax deductions for contributions if you choose to invest in your state’s plan. (Your child can still attend college anywhere.) For example, contributions to a New York 529 plan are state tax deductible up to $5,000 per year by an individual or $10,000 per year by a married couple filing jointly. New Jersey does not offer any state tax benefits for opening a NJ 529 plan, but it does offer favorable treatment when you apply for financial aid from the state of New Jersey, and a NJBEST Scholarship – $500-$1,500 towards first semester of higher education at an accredited New Jersey school.

There are no income limits on 529 plan contributions, so they’re available to everyone. Plans vary, but most have high total contribution limits—usually in the $235,000 to $529,000 range. That said, it’s usually best to keep yearly contributions within the annual gift tax exclusion limit. For 2020, that’s $15,000 for each spouse (or grandparent, relative, friend or any giver) for each child.

Anyone—a parent, grandparent, relative, or friend—can set up an account for a future college student, and there are no restrictions based on age, income, or state of residence. You can even set up an account for yourself. And it’s transferable—if the child doesn’t end up needing all of the money you saved, you can use it for any member of the original beneficiary’s family or yourself.

Cons of 529 Plans

If your child, you or any family member does not want to attend college, and 529 plan money is withdrawn and not used for education expenses, earnings are subject to both income tax as well as a 10 percent penalty tax, and you may have to pay back any state income tax deduction amounts. There is an exception for scholarships—if your child qualifies for a scholarship, you can withdraw up to the amount of that scholarship penalty-free, you’ll just have to pay taxes on the earnings.

There are limited investment options available with 529 plans, and only one investment change per year is permitted. Some have high costs and fees.

The 529 plan is counted as parental income on the FAFSA (free application for federal student aid) whether it is owned by a parent or a child, albeit at a low percent. If the plan is owned by a grandparent, the 529 plan may not be counted, but withdrawals used to pay student expenses may be counted as income on the next year’s FAFSA, potentially lowering eligibility for financial aid.

Roth IRAs

If a 529 plan doesn’t work for your family for some reason, a Roth IRA may be an option. You can withdraw money from Roth IRAs to be used for college expenses for you, your spouse, children or grandchildren as long as the account has been in place for five years. If the account owner is under age 59-1/2, the only tax liability will be on the earnings—if over 59-1/2, the entire withdrawal amount is tax- and penalty-free for any purpose.

The flexibility is there—you can invest in nearly any type of account you want to within a Roth IRA—obviously, you want to find the highest returns and lowest cost/fees. And if your child doesn’t choose to go to college, the money can be used for any purpose, including retirement, with no mandated required minimum distributions, ever. Another advantage of the Roth is that beneficiaries can inherit Roth accounts tax-free—they just have to withdraw all the money within 10 years of the date of original account owner’s death.

NOTE: High-earners can’t open Roth IRAs, and the yearly limit for contributions is $6,000—$7,000 per year for those 50 or older. While a Roth IRA does not show up as an asset for financial aid calculations, amounts withdrawn and used for college expenses are considered income for the next school year, and therefore may reduce the amount of student financial aid that’s available.

Permanent Life Insurance

Permanent life insurance policies, such as whole or universal life, include both a death benefit and a savings/cash account component which you can borrow against to pay for college. Many whole life and similar policies regularly credit the cash account with interest in a guaranteed* amount specified in the policy terms (*guaranteed by the claims-paying strength of the issuing insurance company.)

Interest accrued in the policy grows tax deferred but is taxable if that part of the money is borrowed for any purpose. (In case of death, the death benefit plus remaining cash value usually gets paid out to the beneficiary tax-free.)

While a life insurance policy does not show up in financial aid calculations as an asset, amounts borrowed to pay for college are considered as income on the next year’s FAFSA, as is withdrawing money from a Roth IRA, potentially reducing the amount of student financial aid available.

Life insurance policies often have high fees, and it can take more than 10 years with some policies to surpass what you have paid in premiums. If you are using these to pay for college, consider buying the policy when the child is a toddler with them as the insured to keep the cost of insurance low.

Keep in mind that if you borrow money from the cash portion of a permanent life insurance policy, interest is charged on the amount borrowed until you pay the money back—in essence, you are paying “yourself” back—and regular premium payments must be made to keep the policy in force. NOTE: Some policies allow premiums to be deducted from cash value but watch closely because you could end up with no death benefit and owe money to the insurance company.

Annuities

You can purchase an annuity with a short payout schedule to make payments to cover tuition. Often annuities are costly with high fees, so you may have to contribute a significant amount to achieve the payout needed. In order to make this work in your favor cost-wise, you might need to start early and purchase a deferred annuity policy which guarantees* a high credited interest rate (*guaranteed by the claims-paying strength of the issuing insurance company.)

While an annuity does not show up on the FAFSA as an asset, annuity amounts paid out are considered income the next year, similar to taking money from a Roth IRA to pay for college. So rather than taking annuity payments while attending college, optionally you could take out student loans (interest rates on Parent PLUS federal student loans are anticipated to be around 5.3% for the 2020-21 academic school year), then use the annuity to pay off the loans after graduation depending on interest rates, crediting rates, and whether or not it saves you money in the long run.

How College Savings Can Impact Financial Aid Eligibility

Financial aid for college is determined by The U.S. Department of Education’s calculated EFC (Expected Family Contribution), which is based on a combination of family and student income and assets.

Some people worry that saving money will hurt their financial aid eligibility, but the reality is that income will have a much bigger impact. According to SavingforCollege.com, only 2.6% to 5.6% of your savings is counted on the FAFSA while 22% to 47% of your income is counted. (For the 2020-2021 cycle, if a dependent student and family has a combined income of $26,000 or less, expected contribution to college costs are automatically zero.)

For the average family, concerns about contributing to a 529 plan because of its impact on financial aid are largely overblown, because although it is considered a parental asset (even if it’s in the student’s name), only about 5% of the money inside of a 529 plan is actually counted for financial aid purposes.

Sometimes, shifts can be made to assets which are favorable to more financial aid, but usually this only applies to people with middle-range or lower incomes. As discussed above, retirement accounts, permanent insurance and annuities are not counted as assets on the initial FAFSA. But money withdrawn to pay for college expenses can be counted in subsequent years as untaxed income to the student, potentially lowering the student’s future eligibility for financial aid.

With the exception of 529 plans, which are always counted as parental assets, families with lower incomes may want to consider whose names other assets are held in before they file the FAFSA. If the child has a lot of money in bank savings or mutual funds held in their name, their financial aid eligibility could be impacted. The reason is that parents have something called an “asset protection allowance” in FAFSA of at least $30,000 in asset calculations which students do not have.

Once again, for high income families, whose name assets are held in doesn’t really matter since a high combined family income means you probably won’t qualify for financial aid. In fact, so-called “kiddie tax” advantages may make it more beneficial for children to hold more unearned income assets.

FAFSA (Free Application for Federal Student Aid) and the CSS (College Scholarship Service)

While it is true that life insurance cash values and annuities don’t need to be reported on the FAFSA, the federal student aid form, non-qualified annuities are counted as assets on the CSS Profile, another aid form used by about 300 colleges.

Additionally, 529 plans that are owned by grandparents are not counted as an asset when a student completes the FAFSA, but they do ask for grandparent-owned 529 assets on the CSS Profile “for professional judgment purposes.”

Importantly, distributions from grandparent-owned 529 plans are technically considered a gift to the student, and treated as untaxed income for financial aid purposes, which can impact a student’s aid eligibility by up to 50% of the distribution. So having an asset in the form of a 529 plan account that is owned by the grandparent does not count as an asset in the student’s EFC (expected family contribution toward the cost of college), but if the grandparent makes a distribution from that 529 plan to help the grandchild pay for college, that distribution will be considered untaxed income of the student when the student completes the aid forms the following year.

RESOURCES FOR PARENTS

EFC Calculator: https://bigfuture.collegeboard.org/pay-for-college/paying-your-share/expected-family-contribution-calculator

FAFSA Forecaster: https://fafsa.ed.gov/spa/fafsa4c/?_ga=2.77096277.1341719390.1588887271-908583323.1587677926#/landing

FAFSA: https://studentaid.gov/

CSS Profile: https://cssprofile.collegeboard.org/

All securities offered through The Investment Center, Inc. Bedminster,NJ- Member FINRA/SIPC. Advisory Services provided through IC Advisory Services, Inc.-An SEC Registered Investment Advisor. Sylvan Financial Advisors is not affiliated with The Investment Center, Inc. or IC Advisory Services, Inc.

Sources:

https://research.collegeboard.org/trends/college-pricing

https://www.businesswire.com/news/home/20160615006178/en/Parents-Debt-Fund-Children%E2%80%99s-College-Education

https://www.studentloanplanner.com/student-loan-debt-statistics-average-student-loan-debt/

https://www.savingforcollege.com/article/how-much-can-you-contribute-to-a-529-plan

https://smartasset.com/retirement/lifetime-gift-tax-exemption

https://www.nj.com/business/2018/06/clueless_about_529_plans_heres_a_guide.html

https://www.savingforcollege.com/529-plans/new-jersey

https://www.aboveboardfinancial.com/blog/nj-529-plans-treated-favorably-in-new-jersey-state-financial-aid-calculations

https://www1.nyc.gov/site/opa/my-pay/nys-529-college-savings-program.page

https://www.thesimpledollar.com/investing/529-vs-roth-ira-which-is-best-for-college-savings/

https://thecollegeinvestor.com/21215/roth-ira-paying-tuition/