March 2011


To go along with our current series about planning for college, we wanted to recommend a book that may be a help to you when making decisions about education savings.

529 & Other College Savings Plans for Dummies by Margaret A. Munro is another useful Dummies book. It goes well beyond what we have covered in our series, and describes a number of other options that you may want to consider while planning your strategy for education savings. It’s a fairly quick read, and may help you see the overall picture better on how much it is going to cost to fund your child’s education.

Unfortunately, the book is not very current (published in 2003), so not all the information is still 100% accurate. There have been some changes since then to different plans and tax laws, so don’t use this book as your final authority while doing research. But, it can be useful as a jumping off point for you.

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In the past, we’ve sung the praises of Roth IRAs. They have a number of benefits that make them an excellent choice for retirement savings, though many people wouldn’t consider them to be a good choice for education savings. However, we believe they have some benefits that should make them a consideration.

 

As we have stated, keep in mind we are not discussing all of the information available on Roth IRAs, so make sure you do your own research before deciding which plan to invest in. Also, be sure you understand all the distributions rules as well, especially in regards allowable expenses.

 

Advantages

  • Contributions into Roth IRAs are made after-tax, meaning you will not owe tax when the money is distributed. Also, Roth IRAs are first in, first out. This means that when you take a withdrawal, all of your original contributions come out first before any gains are withdrawn. So, if you make a partial withdrawal from a Roth IRA to fund education, it is unlikely you will have to pay any tax (unlike a Traditional IRA where the gains are withdrawn first). However, if you do withdraw gains and are under 59½ years of age, you will have to pay income tax on the gains, though if you use the money for qualifying education expenses, the usual 10% penalty on gains distributed will be waived. If you are over 59½ years of age (and the money has been in the account for 5 years or longer), the gains distributions will be completely tax free.
  • A Roth IRA’s primary function is for retirement savings. There is no obligation to use it for anything but that. So, if your potential student decides not to pursue postsecondary education, or doesn’t use all the funds, you will have that money for your future retirement, without having to deal with any tax issues.
  • Retirement accounts such as Roth IRAs are not counted as an asset in the calculation for federal financial aid.
  • Investment choices are incredibly flexible. You can invest wherever you want in whatever you want, allowing you to assess your own risk tolerance and the investment performance.

 

Disadvantages

  • Be very careful not to undercut your own retirement savings. While this is true for any type of education savings account, it is especially important to remember if you plan on using a retirement account. So, if you currently use only a Roth IRA to fund you future retirement, it wouldn’t be a good idea to use one for education savings. However, if you have another source of retirement funding, such as a 401(K), and you feel that you have sufficient savings already put away and could continue to fund another account for retirement, a Roth IRA could be a good choice for education.
  • Contributions to a Roth IRA have a number of different contribution rules you must abide by. You need to have earned income in order to contribute (for married couples only one spouse needs to have earned income for both to contribute). Also, there are income limitations on contributions (for 2011, Modified Adjusted Gross Income begins contributions phase out at $169,000 and the limit is $179,000 for married filing jointly, and contributions phase out begins a $107,000 and the limits is $122,000 for single). This rule obviously hampers high income earners from taking advantage of a Roth IRA.
  • Contributions are limited to $5,000 per spouse if you are under age 50, and $6,000 if you are over age 50. Since it is likely you can only contribute $10,000 annually, saving in a Roth IRA is not ideal for late savers, or for parents who have multiple children. $10,000 split between 3 or 4 children will likely not be sufficient in regards to education savings.
  • You can use the funds in a Roth IRA to pay for qualifying educational expenses for yourself, your spouse, your children, or your grandchildren. If you want to contribute to anyone else’s future education funding, it must be in another type of savings accounts.

 

Keep in mind that funding a Roth IRA in itself is by no means the only consideration that should be made while planning for college. Don’t simply max out your Roth IRA s every year and make no other plans. Many people tap their retirement accounts to pay for college without considering other options or the consequences to their own financial future. Please take the time to decide whether you should use a Roth IRA for education savings.

 

Next week we’ll discuss the last account types we’ll cover in this series, Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA).

Coverdell Education Savings Accounts

Unlike Section 529 Plans that we discussed last week, Coverdell Education Savings Accounts’ (ESAs) disadvantages can potential outweigh the advantages for many people. However, Coverdells can still be very useful education savings vehicles if used correctly.

 

As we stated last week, keep in mind we are not discussing all of the information available on Coverdell ESAs, so make sure you do your own research before deciding which plan to invest in. Also, be sure you understand all the distributions rules as well.

 

Advantages

Many of the advantages of a Coverdell ESA are the same as a 529 plan. Those advantages are listed first. The last two bullet points are unique to Coverdell ESAs.

  • The beneficiary of Coverdell ESAs can be changed to a relative of the original beneficiary without any tax consequence. So, if the original beneficiary doesn’t need any of the money or doesn’t use all the money available in the account, then the beneficiary can be changed to a relative (just be sure to research who qualifies before you make a change). Also, there is an age restriction on the account—check out the first bullet point in the Disadvantages section.
  • There are tax advantages to using Coverdell ESAs for education savings. When the money in a Coverdell is distributed to be used toward qualifying educational expenses, the distributions are completely tax free. Also, since Coverdell ESAs’ contributions are after-tax, you can withdraw your original contributions without being taxed again, no matter the reason.
  • Coverdell ESAs are counted as an asset of the owner of the plan, not the beneficiary, in the calculation for federal financial aid. So, if you are the plan owner of your child’s account and you are also seeking federal financial aid, the funds will only be counted for 5.6% as the parents’ assets, instead of 35% as the student’s assets.
  • Coverdell ESA funds can be used toward primary, secondary, and postsecondary education. So, if you know that you would like to send your child to a private primary or secondary school, a Coverdell ESA can be a very useful tool for you (just be sure to check first if the school is eligible). Not only can the funds be distributed for tuition, but it can be used for a number of other expenses as well (tutoring, supplies, computers, required uniforms, etc). This account flexibility makes Coverdell ESAs a good choice for primary and secondary education funding, but many of the same rules (and institutions) apply to Coverdell ESAs as 529 plan when it comes to postsecondary schooling.
  • Coverdell ESA investments are flexible: you can choose where to open the account and what to invest it in (mutual funds, stocks, bonds, etc. – there are restrictions, make sure you know them before investing). This option allows you to do your own research to select what options will be right for your individual beneficiary and your own risk tolerance. However, it also puts the burden of responsibility on you if the investments do poorly (unlike 529 plans where you have no control over the quality of the investments)

 

Disadvantages

  • The money in the Coverdell must be used by the beneficiary’s 30th birthday. If there is money still in the account when the beneficiary reaches age 30, the total balance must either be distributed to the beneficiary, or the beneficiary must be changed to a relative of the original beneficiary who is also under the age of 30. If the funds are distributed, income tax and a 10% penalty will be charge on the earnings from the account (also done with distributions not used for qualified education expenses).
  • Coverdell ESAs have a contribution limit of $2,000 annually per beneficiary (not per account). Not only is there a limit, there is also tax consequences for going over the limit, so always be sure who is contributing to the account and how much. So, Coverdell’s are not useful for late savers hoping to play catch up quickly.
  • Contributions to Coverdell ESAs must end when the beneficiary reaches age 18. This can also be a negative for late savers or anyone who doesn’t plan on the beneficiary starting higher education immediately after graduating from high school. Also, this makes Coverdell ESAs unavailable to any adult looking to fund a return to school.

 

We believe Coverdell ESA are most useful in primary and secondary education, however, they can also be used in conjunction with another type of savings vehicle (like a 529 plan) for post secondary education. Due to its contributions limits, it’s not likely that you would be able to save enough for your child’s entire postsecondary education in a Coverdell ESA (if that’s your goal).

 

Next week we’ll discuss Roth IRAs and their advantages and disadvantages in saving for education.

Section 529 plans are very popular educational savings accounts. They are solid savings vehicles that have many advantages to them, but this doesn’t mean that they are right for everyone. These programs are offered through individual states (making the issue more complicated since each state has its own plan rules). When planning for educational savings, think carefully about your situation, and consider the questions we listed last week.

 

Our goal today is to give you an in depth look at 529 plans and the advantages and disadvantages of these types of accounts. However, this is by no means all the information available, so make sure you do your own research before deciding which plan to invest in.

 

Advantages

  • There are tax advantages to using 529 plans for education savings. When the money in a 529 plan is distributed to be used toward qualifying educational expenses (usually tuition, books, room and board, etc. – be sure to understand the definition before withdrawing any money), the distributions are completely tax free. Also, since 529 plans’ contributions are after-tax, you can withdraw your original contributions without being taxed again, no matter the reason.
  • 529 plans are counted as an asset of the owner of the plan, not the beneficiary, in the calculation for federal financial aid. So, if you are the plan owner of your child’s account and you are also seeking federal financial aid, the funds will only be counted for 5.6% as the parents’ assets, instead of 35% as the student’s assets. Also, since 529 plans can be owned by anyone, if someone other than a parent owns the account, it will not be considered at all in federal financial aid calculations.
  • 529 plan money can be used at a number of different educational institutions, not only colleges or universities. The simple answer would be that if the institution qualifies for the U.S. Department of Education federal aid program and is on the list of eligible schools, 529 plan money should be accepted there without tax consequence. Another way to look at it is if the school is accredited, you will most likely be able to use the funds at that school. However, each state’s program has its own rules, so be sure to know if the schools you and the beneficiary are considering are eligible before choosing a plan.
  • 529 plans are great to save for older students that are running out of time before needing the funds. There is no federal cap on contribution limits, and while each individual state imposes its own limit, they are usually very high. However, you are limited from a gift tax perspective. You can contribute up to the gift tax exemption ($13,000 in 2011, $26,000 for couples). You can also contribute up to 5 years of gifts ($65,000 for an individual, $130,000 for a couple) without triggering the gift tax into a 529 plan, as long as you don’t give any further gifting during the next 5 years. With the potential for such high contributions, 529 plans are often the best choice for late savers.
  • 529 plans are great estate planning tools. Due to the previous bullet point, and the fact that anyone can contribute to a 529 plan for the beneficiary, it can be a tool for family members (especially grandparents) to reduce their estate (and possible estate tax consequences). However, with the 5 year gift tax exemption, if the person who makes the contribution dies before the 5 years are up, the remaining year’s money will be returned to his/her estate.
  • The beneficiary of the plan can be changed to a relative of the original beneficiary without any tax consequence. So, if the original beneficiary decides not to pursue higher education or doesn’t use all the money available in the plan, then the beneficiary can be changed to a relative (just be sure to research who qualifies before you make a change). Also, there is no age restriction on 529 plans, so if you want to change the beneficiary to someone older who wants to return to school, you can do so, as long he/she is a relative.

 

Disadvantages

  • While you have a choice in what state’s plan you choose, you have no control over the investments. There are different types of asset allocation available in the plans (a popular one being age based where investments become more conservative the closer the student comes to using the money). The only recourse you have if the investments are doing poorly in your chosen plan is to withdraw the money (which may have tax consequences – see below) or make a tax-free rollover into another state’s plan (once every 12 months). Since the plans often give no consideration to your own risk tolerance in investing, the account may be too aggressive or too conservative for your beneficiary.
  • Once funds are invested in a 529 plan, they can only be distributed for qualifying education expenses without tax consequence. If they are not, distributed earnings from the account are taxed at your income tax rate, and a 10% penalty is also charged on the earnings.
  • Because of the tax and penalty on earnings for distributions not used for qualifying educational expenses, if the beneficiary doesn’t use all the money in the plan, and you have no other beneficiary to which you can change to, you will have no choice but to withdraw the money and pay the tax and penalties.

 

Hopefully you saw something that will help! Please note that in this post we only discussed Section 529 Savings Plans. There are Section 529 Pre-Paid Tuition Plans which we will not discuss. Next week we’ll discuss Coverdell Education Savings Accounts.

When you are getting ready to have a child, there are many things you need to consider. There are many things you have to buy, rooms to redecorate, and everything else in between. Saving for college may not be at the top of your list. That’s very understandable, but just as with saving for retirement, the earlier you start, the better off you’ll be. So, if you have the intention of helping your child (or grandchild) pay for college, deciding your plan of attack early is the best way to go.

However, since there are a number of options for the types of accounts you can use for saving for education, which one would be right in your situation? For the next month, we’ll be doing a series where we discuss the both the positive and negative aspects of some different savings vehicles for college: 529 plans, Coverdell Education Savings Accounts, Roth IRAs, and UGMA/UTMA (Uniform Gifts to Minors Act/Uniform Transfers to Minors Act). Which type of account is right for you depends on your individual situation, so hopefully discussing each in depth will help you decide. Once you make the decision on the type of account, it will be one last thing you need to think about!

Also, saving for education doesn’t need to be only for children. If you plan on returning to school, saving for that education is something that you need to start considering!

Begin thinking about the following. You will need to decide on the answers to the following questions to be able to decide which type of account would work best in your situation.

  • Who is the account for? Your child, grandchild, yourself, or someone else?
  • How old is the potential student you want to save for? Or in other words, how much time is there until the savings will be used?
  • What kind of school will the student be attending? Is it accredited? Is it public or private? A junior college or a 4 year institution?
  • Do you plan on saving enough to cover the entire cost of the education (tuition, books, room & board)? Or do you plan on paying only for tuition? Do you plan on relying on financial aide?

Next week we’ll start with 529 plans. Have your answers in mind to the above questions!