Financial Planning

10 Ways to Fund Your Children’s College Education – Which is Best for You?

By  Opher Ganel

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Despite the relentless increase in the cost of a college education, such a degree is still incredibly valuable.

If I tell you that not all college degrees are equally valuable, you probably automatically assume I’m referring to the difference between schools, right?

Surely, a bachelor’s degree from Harvard or Yale is worth far more than one from, say, your state university, you’d think.

Surprisingly, research shows that just isn’t so.

The big difference is in the field of study. Some offer lucrative careers, while others, not so much. In a previous piece, I wrote about the 5 ways your kids can ensure the value of the degrees they pursue while minimizing your costs.

Once you know how to maximize the value and minimize the cost, the next question we need to answer is, what’s the best way to fund your kids’ education?

For that, I polled six financial advisors (adding their insights to my own experience). Read on to see all those insights.

Who Are the Financial Pros for College Funding?

Here are the six financial advisors who contributed to this article:

What Options Do You Have for Funding Higher Education?

Your main options are:

  1. 529 college savings plans: Tax-advantaged plans created specifically to save for education that can pay for education-related costs beyond tuition.
  2. 529 prepaid tuition plans: Tax-advantaged plans that let you buy now a set number of years/credits/units of tuition at today’s rates, so future tuition increases don’t affect your cost (available in only nine states – Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Texas, Virginia, and Washington).
  3. Custodial accounts: Uniform Transfers to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) accounts allow parents to invest in their kids’ names, transferring control of the investments to the kids when they reach a state-determined age (19-25). The main difference is that UGMAs can only hold purely financial assets, while UTMAs can hold any asset including, e.g., real estate.
  4. Taxable portfolio: This is your “general fund” of investments.
  5. Current income: This means you pay college attendance costs out of your ongoing family cash flow.
  6. Roth IRA: These are retirement accounts funded with after-tax dollars. However, since they allow penalty- and tax-free withdrawals of contributions (but not earnings) once the account is at least five years old, they can in principle be used to fund educational expenses.
  7. Series I bonds: These bonds offer high interest, currently a 9.62 percent annual rate for the first six months, readjusting every six months. Interest is tax-free if used for educational expenses (Series EE bonds are also possible, but their 0.1 percent interest is dismal).
  8. Scholarships and grants: Since these cost you nothing and can cover up to 100 percent of the cost of attendance, they’re the most desirable option. However, your kids need to apply for these and may receive less than the full cost or even none at all. Some are merit-based, some are based on meeting the granting entity’s eligibility criteria, and some are need-based.
  9. Securities-Backed Lines of Credit (SBLOCs): These are somewhat similar to a Home Equity Line of Credit (HELOC) in that they let you borrow against the value of an asset you own. Instead of being secured by your home like a HELOC, an SBLOC is secured by the value of your taxable portfolio.
  10. Student loans: A method that should be your last resort, these allow you or your student to borrow money to pay for college costs. There’s a wide range of options with different implications. One crucial thing to know is that even bankruptcy doesn’t relieve you of the debt.

Each option has pros and cons, as you’ll see below. The main ones we’ll look at are:

  • Contribution limits (gift tax implications)
  • Tax impacts
  • Impact on financial-aid eligibility
  • Flexibility
  • Degree of parental control over assets

However, we’ll also mention factors that apply specifically to one option or another.

1. The Pros and Cons of 529 Plans

Advantages

Let’s start with the advantages.

Since 529 plans are specifically designed to help you save for college, they’re one of your best options.

Michael Raimondi says, “529 plans are popular because of their flexibility and their tax-free growth (when you spend the money on education), and are ideal for parents who know their hard-earned money will benefit their child due to tax-free growth.

“Certain states give you deductions for your contributions. You can change the beneficiary, transferring from one child to another or even to you or your spouse. You can use it for a range of higher-education expenses, not just tuition, and If a student receives a scholarship, the funds can be accessed without penalty.

Dean Lyman adds, “529 plans are most effective in states where they have a state-tax benefit. They can also be a great way for grandparents to help out grandkids and see the effects of their gifts without waiting until they’ve passed on.

Nathan Mueller says, “With a 529 plan, you often get federal and state tax benefits. If the money is used for qualified education expenses, you may not pay taxes on any earnings. In addition, you may get to deduct contributions from your state tax return. Note, however, that different state 529s have different rules.

Jay Rishel lists several other benefits, “529 plans have no income or age limitations. Anyone can contribute. You keep a lot of control over the account, investment selection, distribution of assets, and beneficiaries. There’s flexibility in the type of education you can pay for, e.g., private K-12 schooling, four-year private college, community college, etc.

“One often overlooked advantage is the beneficial gifting features of a 529. You can front-load five years’ worth of contributions at once without triggering federal gift taxes, which for 2022 is $80,000 per individual or $160,000 per couple filing jointly. 

“Finally, earnings on the money you invest in a 529 grow tax-deferred until you distribute the money. Plus, you won’t pay any federal taxes on the distributions if you use the money for qualified educational expenses.

Finally, Chris Mankoff rounds things out, “529 plans cover qualified expenses at accredited schools, including vocational and trade schools. Parents can withdraw up to $10,000 per year tax-free from a 529 plan for K-12 primary and secondary education tuition at private schools without incurring the typical penalty. You can set up automatic contributions and investments and can benefit from professional management if you prefer a hands-off approach when it comes to investment selection and oversight. Finally, assets in a 529 plan are removed from your taxable estate.

Disadvantages

How about disadvantages? There are some, but not very many…

Michael Raimondi kicks things off, “529 plan balances reduce FASFA eligibility and have penalties for non-education related withdrawals.

Nathan Mueller says, “Not all state plans allow you to use the money towards K-12 education expenses.

Jay Rishel adds, “State taxes may apply on distributions, depending on where you live. If you don’t use the money for qualified educational expenses, a 10% penalty is assessed on investment earnings, and you’ll be subject to federal income taxes (and potentially state income taxes).

Chris Mankoff lists several, “In some plans, investment choices may be limited, minimum investment requirements may apply to the plan itself and/or funds within the plan. Fund fees may be high, and some custodians charge annual fees if your account balance is too low.

IRS regulations only allow you to exchange money from your current 529 investment options to a different option twice per calendar year. However, the automatic changes within target enrollment portfolios don’t count, and you can change the investment options for your future contributions anytime you want.

529 plans are administered by individual states, and a given plan may not offer attractive investment options. Further, each state has a maximum total contribution (per beneficiary) allowed to a 529 plan, so it’s important to pay attention to state-specific limits. The good news is that the state maximum does not apply if the account balance grows past the maximum contribution amount determined by the state.

A 529 plan could potentially be overfunded, and/or the beneficiary may not use all or any of the funds. If the funds are withdrawn for non-educational expenses, you’ll owe taxes on the investment gains at your current tax rate, plus an additional penalty of 10%.

Mankoff then speaks to who would most benefit from using 529 plans, “Anyone who’s interested in a tax-advantaged way to pay for future education expenses while adhering to the 529 plan guidelines. Tax efficiency combined with investment growth potential can provide a larger amount of money for qualified education expenses.

Other Important Facts About 529 Plans

Most states offer them, but the value of these 529 plans varies.

Most states let you deduct all or a portion of your 529 contributions, but three states, Indiana, Utah, and Vermont, offer a state income tax credit, while Minnesota may offer either a deduction or a credit, depending on your adjusted gross income (AGI).

Most states with 529 plans don’t offer a state-tax benefit if you use another state’s 529 plan. Here are seven that do offer that generous benefit: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.

There are eight states without state income tax (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming), and one (New Hampshire) that doesn’t tax wages. Five more states (California, Hawaii, Kentucky, Maine, and North Carolina) do have state taxes but don’t offer any 529-plan state-tax benefits. If you live in any of these 14 states, a 529 plan (from a different state) only confers federal-tax benefits.

If your state does provide tax benefits for 529 plan contributions, you could potentially save thousands (or even tens of thousands) of dollars in state-tax reduction even if you weren’t able to save anything in advance.

2. Using Prepaid-Tuition 529 Plans

If you prefer not to risk the fluctuations of investing, you can use the prepaid-tuition variant of the 529 plan if your state offers it. This option insulates you from any tuition hikes that have historically outpaced inflation by a wide margin. However, these plans don’t help at all with non-tuition expenses such as room and board, textbooks, etc.

3. The Pros and Cons of Custodial Accounts Like UTMAs

Advantages

Let’s again start with the advantages.

Michael Raimondi says, “This account can be appropriate for specific assets with a specific purpose for a child who (ideally) has some financial literacy and is close to their family. They may be most suitable for parents with assets beyond traditional securities and cash, as real estate and other assets can be placed there.

Nathan Mueller adds, “UTMAs allow the most flexibility. You can put in as much money as you want. You can also use the money in any manner as long as it benefits the child.

Chris Mankoff lists several more benefits, “There are no income or contribution limits, no requirements for regular distributions at any point, and no withdrawal penalties. A portion of the gain is tax-free, a portion is taxed at the child’s tax rate, and the remainder is taxed at the parent’s rate.

For 2022, the first $1050 a year in earnings is tax-free, the next $1050 is taxed at your kid’s tax (likely very low) rate, and only earnings above $2100 are taxed at your marginal rate. Once your kid reaches age 18, all earnings are taxed at his or her tax rates.

Mankoff wraps things up here, “If your child receives monetary gifts or inheritance, a custodial account allows you to manage the money until they reach the age determined by each state for the assets to be placed in his or her control. If you want to contribute but aren’t sure if the money will be needed for education, the safest bet would be to put it in a custodial account. You or the beneficiary can move funds from a custodial account to a 529, but you can’t do the opposite without adverse income-tax consequences.”

Disadvantages

And now for the disadvantages…

Dean Lyman cautions, “I hardly ever recommend UTMAs. They convert to student assets when the kid turns 18, and this counts against them in financial aid formulas. The child isn’t required to use the money for education – they could use it for anything. Even a taxable account is better as it keeps the money under the parents’ control, and it has a lower impact on the financial-aid formula.

Michael Raimondi agrees, “The account is legally the child’s asset once they reach the age of majority, so they can use the funds for whatever they desire, even a summer trip to Ibiza, which can be concerning.

Nathan Mueller chimes in, “Once the money is in the account, the parent/guardian/contributor can’t take it out, even if to cover payments for your mortgage or car loan in a financial emergency. It’s considered the child’s money and must be used to benefit them.

Jay Rishel offers specifics on the financial aid impact, “The Expected Family Contribution (EFC) factors in 20% of student assets (including, e.g., UTMA/UGMA assets) when determining financial aid vs. 5.64% of donor assets.

For example, $100,000 in a UTMA would add $20,000 to your EFC, while the same amount in, say, a 529 plan would only add $5640.

And Chris Mankoff adds his take, “Deposit or gifts made to UTMAs/UGMAs are irrevocable – they cannot be changed or reversed, and the beneficiary can’t be changed. Contributing any amount over the annual gift limit of $16,000 for individuals and $32,000 for married couples in 2022 will require a gift tax return. Annual gift tax exclusions in custodial accounts don’t have the same provision as a 529 plan, where you can contribute up to five times the annual gift-tax exclusion at once and spread that exclusion over five years. Finally, assets in a custodial account are included in a taxable estate.”

Addressing who might most benefit from UTMAs/UGMAs, Mankoff says, “Parents or custodians in a favorable tax bracket who value the flexibility to have discretion over the funds until the minor reaches the state-determined legal age of control. For anyone that is concerned that funds may not be needed for qualified educational expenses, a custodial account provides flexibility in how the funds are used without penalty.

4. The Pros and Cons of Your Taxable Portfolio

Advantages

Michael Raimondi says, “A brokerage account offers the most options and the fewest restrictions. That’s why many families believe it’s worth earmarking funds in a standard brokerage account to pay for education.

Dean Lyman agrees, “A taxable account can be used for whatever purpose you see fit, so it may make sense if you think you might not use the money for education.

Chris Mankoff adds, “Taxable portfolios offer significantly more investment options than a 529 plan, as well as access to lower-cost investments. Capital gains in a taxable account aren’t taxed until they’re sold, so the account owner has control over when capital gains occur. The account owner may also be able to take advantage of tax-loss harvesting to reduce tax liability.

Disadvantages

And the drawbacks…

Lyman points out, “You’ll likely have to pay some capital gains taxes to cash out this money, and you pay taxes as you go.

Mankoff adds two more drawbacks, like those of UTMAs/UGMAs, “Taxable portfolios impact financial-aid eligibility, to an extent determined by who owns the portfolio, with the biggest impact if it’s the student’s portfolio; and assets held within a taxable account are included in a taxable estate.

He states that this option is best for “Anyone who prefers to maintain discretion and control over the assets, and when to liquidate assets for education expenses and have to pay taxes.

5. Using Current Income

Using your current income to fully cover education expenses is hard. Given how high college expenses can get (up to $70k a year or more), your income needs to be extremely high. If you can afford this, the main benefit is that you don’t have to set money aside ahead of time.

The drawback is that in most cases if you make enough money to be able to afford this option, you’re unlikely to have any tax benefits.

6. Using a Roth IRA

Dean Lyman makes an interesting case, “One type of account that’s often overlooked for education funding is the Roth IRA. While usually considered a retirement account, if you have after-tax money to be saved, I’d highly recommend using it. You need to have at least a five-year timeframe so you qualify to withdraw the contributions. You’ll need to invest with a shorter timeframe (until college) in mind, but overall it can be a very flexible way to save for education. Then, if money is left over, continue to allow it to accumulate until retirement. Note that you’d only have access to the contributions, not the earnings. Those have to be left in the account until you’re 59 ½.

Three more things to keep in mind here. First, Roth IRAs have income limits, so you can only use them if you don’t make too much money. Second, there are contribution limits that aren’t overly generous, so you won’t be able to fully fund, say, your kid going to a private school, or worse, several kids going to college. Finally, once you withdraw those contribution dollars, you can’t put them back into the account, so you won’t have that money in retirement.

Gifts from a grandparent’s Roth IRA are also possible and would not incur any taxes.

7. Series I Bonds

This idea comes from Nathan Mueller, “People should also consider using I-bonds, which pay really well due to inflation. These are an attractive option because they offer low risk and avoid federal taxes when used for higher education.

8. Scholarships and Grants

As mentioned above, these are the most desirable way to pay for education because they cost you nothing beyond your kid’s time and effort researching and applying for them.

If your income is low enough, your kid’s school may offer need-based aid.

If you or your kid meet eligibility criteria, there are numerous groups out there that offer scholarships and grants, big and small. Obviously, the larger ones attract more applicants and are harder to score.

If your kid excels in school or is an outstanding athlete, he or she may win merit-based and/or athletic scholarships. These may well cover the full cost of attendance from freshman year to graduation.

9. SBLOCs

Todd Pouliot suggests another innovative idea, “Securities-Backed Lines of Credit (SBLOCs) offer a strategic, cost-efficient way to pay for college. These offer timely access to liquidity to pay all or a portion of their child’s college costs, based on the value of their non-retirement portfolio assets. With an SBLOC, parents can pay for college while keeping their wealth intact.

However, the SEC offers a word of caution, “If the value of your securities declines to an amount where it is no longer sufficient to support your line of credit, you will receive a ‘maintenance call’ notifying you that you must post additional collateral or repay the loan within a specified period (typically two or three days). If you are unable to add additional collateral to your account or repay the loan with readily available cash, the firm can liquidate your securities and keep the cash to satisfy the maintenance call.

If this option is of interest, check out this from The Finance Buff.

10. Student Loans

Nearly infinite amounts of digital ink have been spilled about student loans, so I’ll keep this brief.

If you have no better options, student loans may offer a way to cover the cost of getting a degree. However, keep in mind that these have to be paid off eventually (unless you meet the requirements for discharging them through, e.g., certain types of work), and they don’t get discharged even if you declare bankruptcy. As a result, countless young graduates end up delaying major life milestones such as getting married, having kids, and buying a first home.

What I Learned Putting Three Kids Through College

Now that my youngest has graduated, I’ve experienced putting three kids through college, and each was a completely different experience.

Without going into specifics, here are the lessons we learned:

  • Your kid can do a lot to help control college costs:
    • Pick a good school in your state’s university system
    • Do well in high school to win merit-based scholarships
    • Take Advanced Placement (AP) classes and get good grades on AP tests
    • Attend community-college classes while in high school for relatively inexpensive credits
    • Share rental costs with other students when living off-campus
    • Graduate in four years (which likely means don’t change majors or schools in midstream)
  • As mentioned above, a 529 plan can be valuable even if you don’t save ahead of time.
  • One of the biggest gifts you can give your kid (or grandkid) is to help them graduate without any student-loan debt.

The Bottom Line

When saving for your kids’ education, the most important thing is to get started.

As Mankoff says, “Educational costs continue to rise each year, so whichever option you choose, one of the most important decisions you can make is to start now. The typical family will end up paying more for college expenses than expected, and families that don’t save enough often have no other choice than to borrow. The earlier you start saving, the longer your money can grow. Even the smallest contributions add up over time, so you don’t necessarily need a lot of money to start saving today.

Raimondi points out, “With the tax credits available, grants, loans, scholarships, and awards, what feels like a daunting expense can be full of options. Start planning early, and consider inflation in the cost of tuition along with what return on investment you can reasonably expect.

Rishel adds a word of caution, “Don’t forego saving for your retirement in order to help fund a child’s or grandchild’s college education. The student can always use debt to help support their education. You, on the other hand, can’t borrow to fund your retirement.

Mankoff concludes, “If your primary goal is to invest for education, 529 plans offer the greatest tax advantages, control, and flexibility. Custodial accounts can be a good option to transfer wealth for just about anything else.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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About the Author

Opher Ganel

My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals.

Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/.

Disclaimer: To make Wealthtender free for our readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a natural conflict of interest when we favor their promotion over others. Wealthtender is not a client of these financial services providers. Learn how we operate with integrity to earn your trust.