College 529 Plan
Posted September 30, 2018
How do you put your kids through school? Great question. There are several ways to do this beyond the traditional college 529 plan which appears to be the default favorite among parents and financial advisors. But we need to back up the truck a bit, and explore some basic philosophies first.
The Watson CPA Group is full of parents who have teenage kids, and as you will agree there is no guilt like parental guilt. It begins with buying the best car seat, the best shoes, only using organic Gerber’s, installing high speed ventilation systems, etc. Ok, a bit overboard, but you get the idea. So here we are with parents thinking it is their obligation to help children get through college. We tend to disagree, at least philosophically.
We believe that parents want to help their children transition from childhood to adulthood. This is the fundamental motivation behind college funding. How about helping your child buy his or her first house? That seemingly helps a child transition to adulthood. How about starting a business? Many successful people are successful because of business ownership not necessarily education.
Is traditional college going to be the same in 10 years? Are CPAs going to come out of vocational schools or technical institutes where we just train people on how to carry the one and create financial statements? Perhaps.
Having said that, education is a critical transition from childhood to adulthood. College is a wonderful experience beyond the reading and writing, so let’s run through some ideas.
Michigan was the state to pioneer the current look and feel of a college 529 plan, and in 2001 Congress put the final stamp on how this looks today. You can perform your favorite internet search to find a variety of 529 plans, and the associated benefits and disadvantages. These are administered at the state level. For example, CollegeInvest is the provider for Colorado 529 plans. Here are some basics of all 529 plans since they are governed by IRS Section 529 tax code-
You can save for your children (or a myriad of family members such as grandchildren, inlaws, etc.) and the growth of your investments are tax-free provided they are used for educational purposes. Some states, such as Colorado, offer a tax savings at the state level provided you use the state sponsored plan. If you search for 529 plan colorado, you will see CollegeInvest pop up everywhere. And some states, such as Kansas and Arizona offer a tax incentive without forcing you to use the state sponsored provider.
State tax incentives and federal tax savings on growth are the major considerations. But there are some problems. You must use the savings for education, or face a penalty. So if Junior decides to not go to school, the money is captive. Some of these state sponsored programs have high fees and / or below normal rates of return. 529 plans also count towards resources when computing a student’s financial aid application (FAFSA) where as other college savings do not (see below).
College 529 plans are a tool in the toolbox, or a part of layering scheme of educational savings. So before you follow the herd off the 529 cliff, consider the layering options or alternatives.
Roth IRA for College
You can use your Roth IRA towards higher education, and there are several advantages to this approach. First, if you are under 59 1/2 and your Roth IRA is five years or older, you can use the Roth investments towards educational expenses without penalty or tax implications. Conversions work too if you are phased out of Roth contributions or if you have a bunch of IRA money laying around. For example, you could convert a $100,000 IRA (pre-tax) to a Roth at age 50 and then at age 56 you could pull it all out plus earnings for education- all tax and penalty free. Nice!
Roth IRAs are not included on your student’s FAFSA application. This is HUGE. So many parents get jammed up by FAFSA and whatever tax savings was offered by their state is now eclipsed by the pains of FAFSA and financial aid issues.
Let’s not forget that if Junior opts out of going to college, you can re-incorporate your Roth IRA into your retirement planning. College 529 plans offer exceptions if your student gets a scholarship, but not if the student simply bails on the college.
Contact us if you need help modeling the tax implications of converting IRAs to Roth IRAs.
An often forgotten way of saving for college is using life insurance. Not popular, and not because it isn’t a good idea. Using life insurance might not be popular simply because it is obscure. But consider this- no limits, tax-free distributions, and like Roth IRAs the cash values contained in life insurance policies don’t count towards your FAFSA eligibility.
Using life insurance is also flexible. You could have a $50,000 cash value life insurance policy which could be used for education, new house, business startup, new car, etc. all for Junior’s transition from childhood to adulthood.
We can help determine the tax implications of using life insurance funding for college and estate planning.
How Much to Pay For?
If you do some quick searches about the costs of college you will quickly discover that it is ridiculously expensive. But be careful. There are tons of devils in the details and there are some execution fallacies.
Are you paying for every nickel and dime that Junior needs for school? Are you only paying for tuition? How many years? What is your adversion to student debt? Any accountability for Junior to perform well in school?
Here is an option. Have your student take out a loan for fall semester. If they do well, you will pay off the debt up to $5,000 plus pay for spring. This is a great way for your child to have some skin the game when it comes to education. A good adult lesson.
Or another option. Mom and dad will pay for 8 semesters of tuition and books. If your child wants to eat or drink or be entertained, they need to get a job. Or you could float them the first year, and then implement this strategy in year 2.
As referred to before, you could layer your educational savings. We’ve seen people have a college 529 plan with $30,000 per child, with some Roth IRA earmarked for college and some basic savings. This bucket approach or layering approach works well since there are several unknowns.
Possibilities are endless. Again, our thinking is that as a parent you want to help your child transition to adulthood. There are several ways to facilitate this, and your financial experts at the Watson CPA Group can offer some advice.