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An excellent way for a family to save for college, while sheltering income, is a 529 plan and their counterpart, education savings accounts (ESAs or Coverdell accounts). The IRS allows a family to fund a tax-deferred account for a child, which can invest in stock or bond mutual funds and money market funds. 529 plans and ESAs provide a family with an obvious income tax advantage, and a sound strategy for financing college tuitions, which are high, and rising at over 6% annually. Putting income into a college savings account is a no-brainer.
Like anything though, the execution requires planning and financial expertise.
Is there a clinker to all of this? Well, yes. The six-figure question is, “How much will I need to accumulate in a 529 plan?” Coming up with a “529 number” is tougher than it sounds. Should we put in $25,000 or $125,000? A large advisory firm was telling clients to budget for $150,000 per child. I asked them how they arrived at such a nice, round figure. “We’re not sure, but it sounded good.”
Because of the wide array of costs, families don’t know how much or even what to budget. And those costs can vary by factors of five or more. Tuition alone can range from $5,000 to $75,000 annually for undergrad programs. Families assume their child will graduate in four years, yet the nationwide average is 5.3 years. Tuition accounts for only about half of the total cost of college for families who send their child to a state school. According to Sallie Mae, families’ commonly under-estimate the total cost of a four-year college education by 50%.
Creating a financial plan for college is crucial, and that financial plan determines a family’s 529 number.
529 plans and ESAs
There are two choices for tax-advantaged college savings plans: 529 plans and ESAs. Both offer tax-deferred growth, provided the proceeds are used to finance qualified education expenses (tuition, books, computers, and room and board). Though the principal and any gains can be withdrawn tax free from both 529 plans and ESAs, there are important distinctions regarding eligibility and contribution amounts provided by these plans.
529 plans are state-sponsored and each state offers at least one 529 plan. Plans vary by state and differ on fees, features and investment options. Each state plan has a distinct program manager. Your clients are not required to live in a state to participate in that state’s 529 plan, but you should verify that any out-of-state plan offers the same tax treatment and other benefits as your in-state plan.
529 plans offer high funding limits (approximately $300,000, though the exact amounts vary by state) per beneficiary. The sources of funding can include family and friends. Funds held in 529 plans can also be used for K-12 education. For families who are late in establishing a 529 plan, the option exists to “jump start” a plan with a single-year contribution of up to $75,000 ($150,000 for a couple) without incurring a gift tax, provided that a special election is made.
ESAs – have specific limitations regarding who can open them and the annual contribution that can be made.
ESAs can be opened only by couples with an adjusted gross income of less than $220,000 ($110,000 for individuals). The income limit for making a maximum contribution is $190,000 ($95,000 for individuals). Contributions are limited to a maximum of $2,000 per year until the beneficiary is 18 years old
When should you begin funding a 529 plan or ESA?
Because of tax advantages, it is prudent for a client to open and fund a 529 or ESA when a child is born. It is an excellent means of tax deferment. What percentage of the eligible population takes advantage of this tax shelter? Far too few. Most families end up playing catch up when their child enters high school and they’ve forgone the opportunity for many years of tax deferred growth.
How much do you need to fully fund a 529 plan?
It depends. When trying to calculate college costs, the cumulative input costs create a net cost. What are the input costs? The big ones are tuition and fees, living expenses, plus incidentals, multiplied by the number of years required to graduate. Determining the tuition of a specific school is very challenging because tuitions are highly negotiable. Yes, you read that right – see my prior article on Admissions Probability and Negotiating Tuition. When you’ve completed that aspect of the plan, you’ll then need to pencil out the earnings opportunity from the job that the student is preparing for, along with the living expenses of the newly minted graduate, and see if the education investment makes actual financial sense. We all know someone with shiny new degree, lots of student debt, and is working in a job that requires a high school diploma. Long story short, you need a financial plan.
We’ve done the math
My firm offers a free program, the College Business Plan, which calculates all of the input costs for you and your client – tuition and fees, housing, incidentals and every major line item. The program includes in-state and out of state tuitions, as well as the offsets, such as federal, state and institutional grants. We sum everything and show you if you’ll need student loans to get to the finish line. Then we provide you with a pro forma income statement that you can share with your client. This shows the earnings their child will have upon graduation, with all of the living expenses required for the specified region of the country. It includes everything, state and local taxes, healthcare, transportation – all of it. We’ve done the math. Yes, it also includes the 529 number for the family. And it’s free.
If your client’s kid is a bit of a slacker and may require six years to graduate, the College Business Plan offers all of the same data and it’s dumped into an income statement format in an Excel worksheet. It shows all of the same assumptions, modeled on graduation terms of four, five and six years. The incentives to not be a slacker are…sobering. The Excel output is $10.
The bottom line of college financial planning
A 529 plan or ESA provides such good opportunities for accumulating savings for college and putting away income, tax deferred, that they can’t be overlooked. Not knowing how much to save for college is a blind spot, even when families are on the verge of choosing a college. Putting too much into a college savings plan isn’t a good strategy for deferring taxes, as you’ll incur a 10% penalty on withdrawals that are not used for education. Having a realistic 529 number is a key component of a good college financial plan.
The 529 number that a family needs as their savings goal is a great target for them to work towards. As an advisor, you’re providing the family with a value-added service by putting forth that 529 number. Just as importantly, in getting to that 529 number, you’re building a realistic financial plan for college for the family. It is a financial plan that you can implement, maintain and update, as the student goes through college and works toward opening their own investment account with you.
This article has been submitted by Educate To Career (ETC) co-founders, Paul Hill and Michael Havis. ETC is a nonprofit, specializing in providing college planning programs and data to over 1,000,000 families, financial advisors, and campus career centers each year. We are the leading vendor of actuarial analysis of college outcomes data to student lenders. Our charter is to help young people get an affordable education, leading to a real job, with no student debt.
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