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How Do Savvy Investors Plan for Education Expenses?

By Razi Hecht, Wealth Advisor
and Brion Collins, CFP®, CLU, ChFC®, Managing Director

Click Here to Download this Article in PDF Format

A colleague of ours recently shared an interesting story from a baby shower she attended: along with the standard gift registry, the parents-to-be established a 529 college savings plan for their not-yet-born child, sharing the details along with the shower invitation (also mentioning, of course, that the beneficiary would be established once they had a Social Security Number). Though this example may seem extreme, it illustrates a changing reality for many parents: that advanced planning and a long-term strategy for financing your child’s education are becoming more of a necessity than a luxury.

Education funding is one of the largest expenditures most American families will undertake, and costs continue to grow, far outpacing inflation. Today, average costs for just tuition and fees, not including room and board, exceed $33,480 per year for private schools, and $9,650 for in-state residents (or $24,930 for out-of-state residents attending public schools)1.

Funding four years of college, or potentially more, requires forethought, and savvy families need to consider how they will pay for post-secondary education, potentially including both college and graduate school. The best chance we see for a successfully executed savings plan includes getting started well in advance and harmoniously incorporating the right mix of strategies.

Getting Started: Common Types of Education Savings Accounts

Setting up college savings accounts to benefit a child can be done in several ways, the most common being 529 savings plans. Named for Section 529 of the IRS Code, these tuition plans are sponsored by states or educational institutions. Custodial accounts, or Uniform Transfers to Minors Act (UTMA) accounts, are also common and offer different benefits.

529 Plans – A parent, grandparent, or guardian is the owner of a 529 account and remains in control of the funds even after a beneficiary reaches the age of majority. The major benefit is that growth on investments is tax free, with most states offering additional benefits in their plans (such as in-state tax deductions). Most often registered in a parent’s name for the benefit of a child, an owner can also change beneficiaries to another family member (or even themselves). It is important to note that 529 plan assets are considered parental assets from a FAFSA (Free Application for Federal Student Aid) perspective and that funds held in a 529 account may only be withdrawn for post-secondary education expenses, otherwise taxes and penalties may be incurred.

UTMA – For UTMAs, the child receives full ownership of the account upon reaching the age of majority (between age 18 and 21 depending on the state of residency). Unfortunately, gains realized within an UTMA can be potentially expensive; income above a certain threshold may be taxed at a parent’s rate in the so-called “kiddie tax.” At the same time, one major benefit is that funds from UTMA accounts can be used more flexibly for non-educational expenses.

Contributing to Education as a Grandparent

Grandparents who plan to contribute to their grandchildren’s education should keep a few things in mind. Money a child receives from a 529 registered to a grandparent is considered income to the child from a FAFSA perspective and thus counts against financial aid formulas.

To avoid having the benefit of this generous gift offset by the FAFSA reduction, a grandparent can consider several other strategies:

Allowing grandchildren access to the 529 account at a later time in their education. This will prevent the gift from interfering with factors on which FAFSA is based (since FAFSA asks for information based on two years prior).

Depositing the funds into an account owned by the parent for the benefit of the grandchild. Gifters should keep in mind that this strategy may prevent the contributions from being tax deductible unless the state allows tax deductions on deposits into accounts owned by other people, and/or if the grandparents live in the same state, or a state which allows for deductions for contributions to other state plans.

Gifting the funds to the grandchild’s parents and having the parents make a deposit into a 529.  This strategy is beneficial in instances when the parents are not already making contributions that realize the maximum state deduction and have a higher state tax rate than the grandparents.

Use your Gifting as an Estate Planning Strategy

In addition to the future benefits created by education savings, your savings efforts can also aid in reducing a taxable estate. While 529 contributions are subject to the annual gift exemption (currently $14,000 per child annually), gifts can be “front loaded” or given all at once to meet a maximum over multiple years. For example,  a one-time gift of $70,000 would cover 5 years of maximum contributions, but the additional compounding interest in that account would not be subject to a gift tax.

College tuition paid directly to the institution is also not subject to the annual gifting exemption.  An affluent individual looking to avoid gifting limitations like those mentioned above could simultaneously pay tuition expenses directly to the institution and gift to a 529 at the maximum rate. This combination of strategies is most helpful to those looking to reduce their estate by more than the amount subject to the gift tax, and can reduce the need for the 529 funds on the part of the named beneficiary. This way, the  money contributed to a 529 account can grow tax deferred and be passed on to later beneficiaries, even those in the next generation.

Additional Tax Credits, Exemptions and Deductions

Most wealthy investors assume they are not eligible for certain education-related tax credits or deductions. However, that may not be the case based on individual circumstances. A first step is to consider the tax situation of each family member as well as that of any potential contributors.

Adjusted Gross Income (AGI), taxable income, and your state of residence will impact the credits, exemptions, and deductions available to you when paying for education.  While a parent may not be eligible for an education tax credit due to their AGI, his or her child might be able to claim themselves as a dependent. For example, one of our clients had a daughter who had recently graduated and was working full time and completing her first tax return. Because the client’s daughter was providing her own support, she realized she was eligible for the American Opportunity Tax Credit for tuition paid in her final semester of college. By integrating the daughter’s situation with that of the parent, the family saved $2,500 in taxes. It is important to note that these education expenses, if used to claim a tax credit, cannot be reimbursed through 529 funds.

Additionally, if you are in a position to affect your final AGI, you might find it advantageous to do so. Another client of ours was experiencing a soft year in their business and the family had not yet contributed the maximum to their 401(k). Given the lower business income, the client was expected to have an AGI right above the threshold to qualify for the education tax credits. By increasing 401(k) deferrals during the year, the client qualified for a portion of the education tax credit.

Use of Funds for Education

It is important to know the rules on what types of expenses are eligible under 529 plans and when those funds are available for withdrawal to avoid penalty. Using funds for anything other than qualified post-secondary education expenses can cause tax, penalty, and a recapture of the state tax deduction. A list of qualified education expenses can be found at www.irs.gov/credits-deductions/individuals/qualified-ed-expenses2. Also, withdrawals must be taken from the account for the beneficiary who incurred the education expense. Taking from another’s account, say a sibling, will subject the funds to the above-mentioned penalty and taxes.

Many education expenses for different types of higher education institutions are eligible, however, some are subject to limits. For example, someone living in off-campus housing might still be able to use 529 funds for some of the expenses, but these costs are limited to the housing expenses delineated by the college’s financial aid department.

Both the timing and the amount of withdrawals are important as they can impact financial aid and education credit eligibility.  Generally, withdrawals should be taken in the same calendar year as the expense occurred.

Changing Beneficiaries

When there are unused funds in a 529 account after the beneficiary has completed college, one sound strategy is to change the beneficiary. For example, the new beneficiary could be a younger sibling who has yet to complete college, or an older sibling with remaining graduate school expenses. A theoretical example of a new account owner could be an adult child assuming ownership to jumpstart the education funding for a current or future grandchild. It is important to be aware that this change of beneficiary can be considered a gift for gift tax purposes – please consult with your advisor and accountant to ensure the process is handled correctly.

Conclusion

Thoughtful education planning can incorporate a combination of strategies, such as those mentioned here, and can ultimately establish education funding for multiple generations within a family. Successful strategies can also provide gifting and estate planning opportunities for parents and grandparents. Working with both your financial advisor and accountant is the best way to structure a successful education planning strategy that works best given your personal financial situation.
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trends.collegeboard.org/sites/default/files/2016-trends-college-pricing-web_0.pdf

www.irs.gov/credits-deductions/individuals/qualified-ed-expense

Bronfman E.L. Rothschild is a registered investment adviser (dba Bronfman Rothschild). Securities, when offered, are offered through an affiliate, Bronfman E.L. Rothschild Capital, LLC (dba BELR Capital, LLC), Member FINRA/SIPC. © 2017 Bronfman Rothschild
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This information should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The commentary provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Bronfman Rothschild cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use. Past performance does not guarantee future results.

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