Financial Planning for College

Typically when the topic of “financial planning” arises, the focus is on retirement. However, another looming concern for young families is planning for college. Much like retirement planning, the goal oftentimes seems like a distant concern, but as is the case with time, it moves faster than we anticipate, and college is here before we know it. Many parents of young children are daunted by the various strategies and vehicles that are accessible to them as options to meet this goal, and the end result is that they put off saving.

As with most investments, the most important factor in achieving success is time; allowing compounding to take place, uninterrupted, over a long time horizon. While the average employee may have forty years to save for retirement, the average parent only has eighteen years to save for college, so the earlier you can start taking advantage of compounding investment returns, the more likely you will achieve success in providing for your child’s college tuition.

The most important factors in meeting the college goal are:

1. Maintaining the appropriate savings rate consistently over the accumulation period
2. Maintaining an appropriate asset allocation for the duration of the accumulation (and spend down) periods
3. Utilizing the correct vehicles to hold those investments

In a world of unknowns, it is not only difficult, but impossible to accurately predict the end results of the multitude of variables and assumptions which go into the beginning phases of a plan: will my child go to an expensive private school or a more cost-effective public school, will my child receive scholarships or financial aid, will tuition inflation be as high as it has been historically, etc. These variables do not provide enough reason to warrant the avoidance of saving for college altogether; rather, they support the approach which focuses on using realistic assumptions to develop a strategy which provides for a reasonable chance of success, while trying to maintain as much flexibility as possible in the event of unforeseen circumstances arising.

Savings Rate and Asset Allocation

There are many resources online which can be helpful in determining an approximate savings rate based on the specific assumptions inherent in any individual plan; however, you should verify these results with a qualified financial advisor before taking any action. There are fairly basic calculations to determine an appropriate lump-sum funding amount or annual savings amount, but even is a simple calculation is not simple, and must consider inflation and the time value of money. Your financial advisor should be able to assist you with either a basic, or a more complex strategy for determining the required annual savings for college. If the desire is to increase the detail and accuracy of the calculations, there are software available through which an advisor could: 1.) compare between the different required savings amounts for tax-free accounts versus taxable accounts, 2.) pull in costs for specific schools, and 3.) adjust the risk and return profile to compare various outcomes associated with various investment strategies.

Unsurprisingly, the overarching investment strategy for a college savings plan is generally fairly simple: it begins in the early stages with a heavier weighting towards stocks (carrying more risk but the potential for greater growth), and gradually transitions throughout the savings period such that as the beneficiary nears college, the assets are comprised primarily of bonds and money market (reducing risk and transitioning to asset preservation). Some 529 College Savings Plans (more information below) offer funds which function similarly to a target date retirement fund, automatically managing the asset allocation as the beneficiary nears college, while others offer the flexibility of managing the allocation in a more “hands on” approach. Regardless of the approach, the asset allocation decisions are paramount in maximizing the investments’ potential return over the saving period, and it is often beneficial to work with a qualified advisor.

Determining the Appropriate Vehicle

As previously mentioned, there are many different strategies involved in saving for college. The scope of this article is limited to the differences between two commonly used approaches: the Section 529 College Savings Plan, and Uniform Transfers to Minors Accounts (UTMAs). (Please consult with a qualified financial advisor before opening or funding any accounts.)

Some of the most common considerations when comparing these two accounts are:

• Tax Structure and Benefits
• Control
• Flexibility
• Financial Aid

Tax Considerations

Once contributions have been made to a 529 plan, all earnings grow tax-deferred (meaning the owner is not depleting the assets each year as they pay taxes on dividends, interest, and/or capital gains), and distributions from the 529 plan are tax-free, as long as they go towards educational expense. The implication here is that it is possible to increase the final after-tax savings in a 529 plan over a taxable account.

The UTMA approach is not a tax-sheltered account; however, in the current year, any unearned income for children below $1,300 (2024) is not taxable. Some view this as a benefit from a taxation standpoint. However, depending on how aggressively the account is funded, it is possible (and likely) to exceed this amount from an income standpoint, and if capital gains are factored in (which is likely considering that the glide path of the allocation will shift frequently from 100/0 to 0/100 – or some similar ratio – throughout the accumulation period (requiring investments be liquidated periodically)), that possibility becomes highly likely. Even if tax-efficient vehicles are used during the accumulation period, as assets are liquidated for distribution during college, those gains will produce a higher tax liability, which will reduce the dollars which are able to fund tuition.

Control

A UTMA account generally becomes the legal property of the child at his or attainment of age eighteen or twenty-one, depending on the state. (For Texas, control passes to the child at age twenty-one.) Oftentimes a child will still be in school at this age. The parent, at this point in time, would turn over control of the account to the child, and whether he or she decides to use the remainder of the funds for school, or to spend it on something else, is now up to the child, and the parent loses oversight. The 529 plan, on the other hand, remains in the control of the owner (typically the parent or grandparent) indefinitely. Some view this as a benefit, especially since it is difficult to predict the level of responsibility a child will have so far in the future.

Flexibility

The obvious reason that one would save in a UTMA versus a 529 plan is to mitigate against the risk that the child does not need the funds for higher education (either does not choose to attend school or receives scholarships). This would create problems for money held in a 529, as it would be taxed and penalized if withdrawn for purposes other than education. The UTMA at this point in time, could continue to be used for the child’s benefit, regardless of whether that may be education, a down payment on a home, starting a business, etc. For this reason, some parents will overweight savings in their older child’s 529, so that if the older child doesn’t use a portion or any of it, they can roll the savings down to their next child (tax and penalty free) to be used for his or her education. If the older child does not attend school, there is flexibility. If the younger child does not attend school (or gets a full scholarship) and the parents have no other qualifying family members for whom they wish to cover the cost education, then there isn’t much you can do with those savings without paying taxes and a penalty. That being said, there have been recent legislation changes which allow a 529 owner to roll assets from a 529 plan (for whom their child is the beneficiary) into a Roth IRA for the child, giving the child a head-start on retirement. There are, however, many stipulations required by the IRS, one of which is that the 529 must have been opened for at least fifteen years. Additionally, no assets (or earnings on those asses) which were contributed in the last five years are eligible for a rollover.

Financial Aid

When financial aid is being determined, assets of the parent and the child are taken into consideration. Both of these account types will count against how much financial aid a child can get for college; however, generally the 529 assets count for less, and utilization of a 529 plan results in more financial aid being approved than the UTMA. Interestingly, it seems that when the child’s grandparent(s) owns a 529 plan for their benefit, it doesn’t count against how much financial aid the child may be approved for. In this instance, two parents who are married could make gifts to the grandparent of up to $36,000/year (2024) with which the grandparent could fund the 529s, thereby not counting against the child’s financial aid. (Please consult with a qualified CPA before considering any tax strategies.)

Conclusion

There are many considerations which go into developing a college savings plan. There is no right or wrong approach, as long as you have a plan and stay consistent. Some parents choose to enjoy the control and tax benefits of the 529 plan, while others prefer the flexibility of the UTMA. Some employ use of both and allocate their savings between the two. Some utilize the 529 to provide for a reasonable estimate of college tuition costs but continue to save in their own taxable investment accounts with no goal in mind with the intention that they will make up any shortfalls from their own money. If money is distributed and paid directly to a qualifying institution of higher education, then gift taxes are generally not a concern. Consistency and endurance are of paramount importance in any financial endeavor. There will always be a higher likelihood of success when savings rates are consistent, and when the investor sticks to the investment strategy, taking advantage of all the available years of compounding.

Always remember to view your college savings goals within the context of your other financial goals, namely, retirement. A qualified financial advisor should be able to advise as to whether your college goals are realistic in relation to your retirement plan, or conversely, whether your college savings goals represent a potential detriment to your retirement goals. Always consult with a CPA, attorney, and qualified financial advisor before making any tax, legal, or investment decisions.

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