The average cost to attend ALL types of colleges is rising higher than inflation rates year after year. Generally, there are four savings vehicles that can work well for college funding for high-income earners.
A common goal to address once one’s own financial strategy is secure and in good order is to begin to help your kids or grandkids to invest in their futures through savings earmarked to fund further education. The tough part to pin down is how and where to be saving for this goal.
The base of this article will begin to address these questions and shed some light on the options and choices available. Generally, there are four savings vehicles that can work well for college funding for high-income earners.
1. 529 plans
The distributions of these accounts have to be used for room, board, tuition, books and qualified educational expenses (which continue to evolve into a fairly comprehensive list). 529 plans are available on an individual basis per each state. These savings vehicles allow any individual (relative or non-relative) to fund the account at any point. The child may attend almost any two- or four-year college or a trade school.
The nice thing for most physicians is that 529 plans do not have income restrictions on who can utilize them. You also can use any one state’s plan for any school in the country, so they are fairly flexible all around in that regard; however, you may lose out on certain tax advantages if you invest in a 529 plan from a state in which you do not reside.
The dollars in a 529 plan grow tax-deferred and can be pulled out tax-free for the reasons mentioned above. If the withdrawals are not for a qualified educational expense, then any earnings will count as ordinary income and also be subject to an additional 10% penalty. The only way you may avoid these taxes and a penalty is if the money is taken out due to death or disability of the beneficiary or if all costs were covered from the proceeds of a scholarship (timing of the scholarship and withdrawal may be an issue).
One should note that the earnings from these funds are taxed at ordinary income rates. The funds themselves are typically managed by a fund family that has been previously set up by the state. Typically fund families are Vanguard, American Funds, ishares, BlackRock, TIAA-CREF, etc. Most fund families that run these plans often make age-based plans available or individual funds. The age-graded funds start off fairly aggressive in investment mix when the child is young and eventually get more and more conservative in risk as the child approaches age 18.
The individual fund options that are available allow you or your financial advisor to customize a portfolio based on your personal objectives and risk tolerance and can be tailored very specifically. Individually constructed portfolios typically require a bit more monitoring throughout the accumulation phase. The account owner also has complete control over where and when the distributions occur, so the beneficiary does not have discretionary use of the funds.
Each state has its own specific 529 plan and a decent number of states actually allow a certain amount of annual contributions to be written off against your state specific tax liability. Even if you do not like your specific state plan, you should consider the potential tax benefits it may provide over another state's plan. 529 balances can be transferred once per year either to different plans or between related beneficiaries.
To find out if your state allows for a tax deduction or to research your investment options, I would recommend starting your research at savingforcollege.com. Ultimately though, I would recommend reaching out to a professional who is well versed in college funding for specific advice and investment education.
2. Uniform Transfer to Minors Act (UTMA)
Another popular savings tool for children is a UTMA. Annual gift tax limits apply to this. Currently, the transfer is a maximum of $13,000 from one person to another; so a set of parents or grandparents can transfer $26,000 to one individual gift tax free.
Although you can put almost any asset into a UTMA, typically for college one would invest in mutual funds, stocks or Exchange Traded Funds. The nice part of a UTMA is that the money does not have to be earmarked for anything in particular, as long as withdrawals are made for the benefit of the beneficiary.
Another upside to utilizing these accounts is the tax benefits on the growth of equities. In 2012, the first $950 of investment income is tax free. The second $950 of growth in an account of this nature is taxed at the child’s income tax rate, which in most cases is at the 10% or lowest marginal tax bracket. Any investment growth beyond $1,900 per year is then taxed at the parents’ marginal tax rate. The potential downside of funding these accounts is that the child has complete control over these funds when they reach the age of majority, which can range from 18 to 25, but most often is 21 years old.
3. Cash value life insurance
Using life insurance as an accumulation tool can also be an advantageous way to accumulate assets for college savings. There is quite a bit of detail that you would need to learn about the inner workings of properly structuring a policy of this nature, but the main advantage is that a portion of the life insurance premium goes into the cash value of a life contract and grows tax-deferred. This cash value can be loaned from the policy without incurring income tax consequences.
A large advantage of this account is that you receive very similar tax breaks as a 529 but also can retain control. The downside to using these is that you typically have to pre-fund the true life insurance costs in the first few years, which pushes the breakeven point of the initial costs to the benefit of the tax deferral and compounding of the investments a significant amount of time in to the future, which requires some foresight to plan far enough ahead to make this vehicle’s structure worth it.
Policy loans and withdrawals may create an adverse tax result in the event of a lapse or policy surrender, and will reduce both the cash value and death benefit. Please, keep in mind that the primary reason to purchase a life insurance product is the death benefit. Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender periods. Policy holders could lose money in this product.
4. Non-qualified brokerage accounts
Of course, any savings is good savings at the end of the day and one could always save money in an independent brokerage account. This would be an account in your name and that you have complete control over. You can choose your investments to be any stock, bond or mutual fund out there and can manage the risk to suit your tolerance and time horizon for the use of the funds.
The downside is that you will be subject to paying capital gains tax on any realized gains (currently the rate is 15% and could potentially be bumped to 20% with the fiscal cliff needing to be addressed by congress).
Rising cost of college
Once you know what vehicle(s) are best suited for your savings goals, then it becomes a matter of how much to save. This can be a fairly tricky number to pin down for a young child with so much time to pass yet before the money will be used, but a few trends should be noticed. The average cost to attend ALL types of colleges is rising higher than inflation rates year after year.
The cost of attending a four-year public university rose roughly 160% over the last decade; the average tuition was $8,653 a year in 2000 and closed at an average of $15,014 a year during the 2009-2010 academic year. Private four-year schools in 2000 were averaged at $21,856 and they also took a sizeable jump to average at $32,790/yr at the close of the decade (source: National Center for Education Statistics).
Savingforcollege.com cites that the 10-year historical rate of increase as of 2011 for college tuition was 6%. If this rate were to continue into the future, the
would suggest total costs could double every 12 years!
542155/ DOFU 8-2012
Jon C. Ylinen is a Financial Advisor with North Star Resource Group and offers securities and investment advisory services through CRI Securities, LLC. and Securian Financial Services, Inc., members FINRA/SIPC. CRI Securities, LLC. is affiliated with Securian Financial Services, Inc. and North Star Resource Group. North Star Resource group is not affiliated with Securian Financial Services, Inc. The answers provided are general in nature and are not intended to be specific recommendations. Please consult a financial professional for specific advice in relation to your individual circumstances. This should not be considered as tax or legal advice. Please consult a tax or legal professional for information regarding your specific situation.
Investments will fluctuate and when redeemed may be worth more or less than originally invested.
A 529 college savings plan is a tax-advantaged investment program designed to help pay for qualified higher education costs. Participation in a 529 plan does not guarantee that the contributions and investment returns will be adequate to cover higher education expenses. Contributors to the plan assume all investment risk, including the potential for loss of principal, and any penalties for non-educational withdrawals.
Your state of residence may offer state tax advantages to residents who participate in the in-state plan, subject to meeting certain conditions or requirements. You may miss out on certain state tax advantages should you choose another state's 529 plan. Any state based benefits should be one of many appropriately weighted factors to be considered in making an investment decision. You should consult with your financial, tax or other advisor to learn more about how state based benefits (including any limitations) would apply to your specific circumstances. You may also wish to contact your home state's 529 plan Program Administrator to learn more about the benefits that might be available to you by investing in the in-state plan.