Many parents in the past few months have faced the daunting task of writing a sizeable check to universities to cover their child’s fall semester tuition. While writing the check, I am sure many were asking themselves why they did not save more money for this event.
According to College Illinois!, a prepaid tuition program, the average cost of tuition and fees at Illinois public universities for 2014-15 is $13,984. The most expensive is the University of Illinois at Champaign with annual tuition at $20,606. The cheapest is Governors State University at $9,994. Locally, Southern Illinois University Edwardsville is $10,292.
Of course, parents who have sent their kids to college know these costs are just the beginning. Room and board, computers and traveling back and forth to campus can be equal to or more costly than tuition.
So how do parents effectively save money to help pay for future college expenses? There are several choices, and the right one should consider factors such as taxes, flexibility and cost.
529 College Savings Plans
In my opinion, a 529 college savings plan is a great way to save for college and is hands down the best choice.
Although state governments created college savings plans many years ago, they did not become popular until the IRS created IRC Section 529 in 1996 to provide federal tax deferral of earnings for these state plans. The enactment of the Economic Growth and Tax Relief Reconciliation Act on June 7, 2001, provided further congressional support for Section 529 plans by completely exempting the earnings of the plans from federal taxation when used for higher education.
Today, all fifty states have their own Section 529 plan, which can be confusing. Each state plan has a different set of investment options, contribution limits, expenses, etc. You do not need to live in a particular state to use their plan and do not need to go to college in any particular state. For example, a student could live in Illinois, go to college in Indiana and pay for it with money from the Missouri 529 plan.
A great website to visit is www.savingforcollege.com, which provides information on every state plan available. Most states provide the option of opening an account directly, or you can also find a financial advisor to help with the process. In Illinois, BrightStart is the name of the direct plan, while BrightDirections is the plan used by financial advisors.
Benefits of 529 College Savings Plans
Investments in 529 plans are with after tax dollars. However, as long as the withdrawals are used to pay for education related expenses, the earnings are exempt from federal taxes.
Some states offer tax deductions for contributions. In Illinois, contributions to the Brightstart Plan (www.brightstartsavings.com) are deductible on your state tax return. The contribution limit per person is $10,000, which could save $500 in state taxes.
You are the owner of the 529 Plan account and maintain full control of investments and withdrawals. Despite this control, the asset is not considered to be part of your estate for tax purposes.
The beneficiary on the account can be changed once per year. This allows you to use the money for different children, or even yourself. There is no withdrawal requirement at specific ages, so the accounts can be passed on to future generations. The assets of the plan can be used for undergraduate, graduate school, trade school, law school, etc.
There are no income limits and anyone can contribute, regardless of income. Grandparents can contribute for their grandkids, for example. Annual federal gift limitations should be considered. More information about current federal gift limitations is provided at the end of this article.
Things to consider about 529 Plans
If withdrawals are not used for qualified expenses, the earnings are subject to taxes and a 10 percent penalty. This penalty may be waived if your child receives a scholarship, becomes disabled, suffers a hardship or in the case of a death.
The investment choices are limited to those within the state’s plan. Each plan chooses a sponsor and creates a list of investment options.
These assets may affect financial aid. See the table at the end of this article for additional information.
Other choices for saving
There are other savings options in addition to the 529 College Savings, but they do have some drawbacks to consider. See the table at the end of the article for a high-level comparison of options.
In 529 Prepaid Tuition Plans, you essentially pay for semesters in advance with a set schedule of payments. These are quite complicated, are not flexible and you lose control of the asset. In addition, there have been questions – especially in Illinois – about the plans being significantly underfunded and lacking state guarantees.
A savings account is easy, flexible and free, but the money will likely earn very little interest. Current interest rates are low. Interest earned is fully taxable.
A custodial account (UTMA/UGMA) is an irrevocable gift to the minor and the money does not need to be used for college. When the minor reaches the age of majority, which is 18 in Illinois, they are free to spend the money however they choose.
The contribution limit for a Coverdell Education Savings Account (Education IRA) is $2,000 per year and the money must be withdrawn by the time the beneficiary reaches age 30.
Compare savings options
| YEAR 2014 RULES | 529 Plan | Coverdell Education Savings Accounts | Custodial Account (UGMA/UTMA) |
| Federal Income Tax | Non-deductible contributions. Withdrawn earnings excluded from income if used for qualified higher education expenses | Non-deductible contributions. Withdrawn earnings excluded from income if used for qualified higher education expenses. Qualified K-12 expenses also excluded | Earnings and gains taxed to minor. First $1,000 of unearned income is tax exempt. Unearned income over $2,000 for certain children through age 23 is taxed at parents rate |
| Federal Gift Tax Treatment | Contributions treated as completed gifts. Apply $14,000 annual exclusion, or up to $70,000 with 5-year election | Contributions treated as completed gifts. Apply $14,000 annual exclusion | Transfers treated as completed gift. Apply $14,000 annual gift exclusion |
| Federal Estate Tax Treatment | Value removed from donor’s gross estate. Partial inclusion for death during a 5-year election period | Value removed from donor’s gross estate | Value removed from donor’s gross estate unless donor remains as custodian |
| Maximum Investment | Established by the program, with many in excess of $300,000 per beneficiary | $2,000 per beneficiary, per year combined from all sources | No limit |
| Qualified Expenses | Tuition, fees, books, supplies, equipment, special needs, room and board for minimum half-time students | Tuition, fees, books, supplies, equipment, special needs, room and board for minimum half-time students. Additional categories of K-12 expenses | No restrictions |
| Able to Change Beneficiary | Yes, to another member of the beneficiary’s family | Yes, to another member of the beneficiary’s family | No. Represents an irrevocable gift to the child |
| Time/Age Restrictions | None, unless imposed by the program | Contributions before beneficiary reaches age 18, use of account by age 30 | Custodianship terminates when minor reaches age established under state law, which is generally 18 or 21 |
| Income Restrictions | None | Ability to contribute phases out for incomes between $190,000 and $220,000 (joint filers) or $95,000 and $110,000 (single filer) | None |
| Federal Financial Aid | Counted as asset of parent if owner is parent or dependent student | Counted as asset of parent if owner is parent or dependent student | Counted as student’s asset |
| Investments | Menu of investment strategies as developed by the program | Broad range of securities and certain other investments | As permitted under state laws |
| Use for Non-qualifying Expenses | Withdrawn earnings subject to federal tax and 10 percent penalty | Withdrawn earnings subject to federal tax and 10 percent penalty | Funds must be used for benefit of the minor |
Brad Keene is a Wealth Management Advisor, Portfolio Manager at Visionary Wealth Advisors. He is a CERTIFIED FINANCIAL PLANNER (TM), holds an MBA from St. Louis University and a B.S. in Finance from Eastern Illinois University. He has been advising clients since 1996 and is a lifelong Collinsville resident. Contact Brad at brad.keene@vwa-llc.com.
