Investing in your family’s future can look vastly different from person to person depending on priorities, lifestyle, and ambitions for their heirs. One avenue of providing financial support for the next generation is through education savings, which can provide value for multiple decades. As the cost of higher education continues to rise, so has the importance of building a plan to save for this future expense. Education savings provide financial security and offers peace of mind, ensuring that the next generation can access quality education without incurring excessive debt.
It is no secret that the cost of education, specifically higher education, has risen dramatically in the past few years. Over the past two decades tuition and fees at in-state public universities has increased by 56%, even with an adjustment for inflation. Tuition is not the only expense to manage with higher education, as there are books, supplies, housing, and transportation to name a few that will increase the amount needed for this endeavor. This upward trend is expected to continue, which can put an excessive financial burden on the student to make ends meet while trying to obtain a degree. These rising costs make it all the more important to start planning as soon as possible.
One of the most effective strategies for managing future education costs is to start saving and investing early. The earlier you begin saving, the greater the opportunity that your money has to grow. This can significantly reduce the amount the student is responsible for paying towards their own education. Even if saving begins with small contributions, the key is to make education savings a priority as soon as possible since distributions typically begin when the child is 18 or 19 years old. There are several types of accounts that can be utilized for education savings, each with its own set of benefits and drawbacks. Since saving for education begins when the child is a minor, parent-controlled accounts are available to ensure responsible management of the assets. Understanding these options can help families choose the best plan for their needs.
Custodian accounts, established via the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA), can be used for any purpose for your child, inclusive of education. However, custodial accounts do not offer specific tax advantages for education savings and spending, and they may have an impact on financial aid eligibility. Another savings vehicle is education trusts, which can provide customized control over how the funds are invested and subsequently distributed. Trusts come with tax advantages and can be used to meet specific familial goals, but they also require legal assistance to establish and maintain, which can add to the overall cost. The most common education savings account is the 529 education plan. These plans are specifically designed for education expenses, and come with many tax benefits, but have certain limitations on the investments and customization available. Understanding the ins-and-outs of a 529 plan can be tedious, but some of the highlights are listed below.
Investment grow tax-deferred within a 529 account. This means that while the money is in the account, any interest, dividends, or capital gains accumulate without being subject to capital gains or income taxes. This can help the savings grow more rapidly compared to a brokerage account. You can withdraw monies from a 529 account tax-free to pay for qualified education expenses, which include costs required for enrollment and attendance at in-state, out-of-state, public and private colleges, universities, or other eligible post-secondary educational institutions. Qualified 529 plan expenses also include up to $10,000 per year in K-12 tuition expenses.
529 plans offer the flexibility to change the beneficiary, or student. If the original beneficiary does not end up needing the funds for education, then the beneficiary can be changed to another family member such as a sibling, cousin, or even yourself. This allows the money to potentially be used for education in the future, thus preserving the tax advantages. There are certain limitations on who the beneficiary can be changed to depending on the relationship to the original beneficiary.
529 plans do not have a time limit on when the funds must be used. This means that the money can remain in the account indefinitely, which could be beneficial if you anticipate future educational expenses like pursuing a master’s or doctorate degeree – even if that is many years down the road. This feature can provide a hedge against the unpredictability of educational needs.
If the funds are withdrawn for non-educational purposes, they will be subject to both federal income tax and a 10% penalty on the earnings portion of the withdrawal. However, there are exceptions to the 10% penalty, such as if the beneficiary receives a scholarship, attends a U.S. military academy, becomes disabled, or passes away. In these cases, while the earnings are still subject to income tax, the penalty is waived.
Contributions to a 529 plan are considered completed gifts for federal tax purposes and are removed from the donors taxable estate, and not subject to the federal gift tax up to a certain limit. This can make 529 plans an attractive option for grandparents or others who want to reduce the size of their estate while adding to their overall gifts for their heirs.
While higher education savings usually takes the bulk of the education expenses, 529 plan monies can also be used to pay for K-12 education costs up to $10,000 per year. Also, in certain circumstances if money is leftover in the 529 plan with no other eligible beneficiaries, the monies can be rolled into a Roth IRA for the child. Rolling the leftover 529 assets into a Roth IRA maintains the tax-free nature of the growth of the monies. There are many nuances to this option that we encourage consulting with a trusted advisor about before going down this path.
Saving for education is a critical aspect of financial planning that requires careful consideration and early action. By starting early, choosing the right savings plan, and integrating education savings into a broader financial strategy you can ensure your children have the resources needed to pursue their educational dreams without the burden of overwhelming debt. We believe working with a trusted advisor to provide sound guidance and consistent monitoring of the plan can increase the likelihood of meeting this critical goal. Our team at LGT Financial Advisors specializes in working with parents and grandparents to establish a lasting legacy through the gift of education, and we invite the conversation with our team of experienced advisors.