5 steps to consider when saving for college
By Christian DiRusso CFP®, CPA, Financial Planning Specialist, Altfest Personal Wealth Management
Whether your children have just started kindergarten or are about to graduate from high school, it’s likely you’ve got the daunting expense of their higher education on your mind. As a financial advisor at Altfest Personal Wealth Management who works with many families facing this challenge, I’d like to offer you a few savvy strategies to consider for paying for college.
1. Weigh the options
First, start with calculating the return on investment (ROI) for different college degrees your child may want to pursue, at a variety of institutions. This involves determining the total cost of the degree program, finding the average starting salary for that career, then dividing that annual wage by the tuition cost. The higher the quotient, the better the ROI of a given degree.
It’s also important to think at an early stage about how much you, as parents, are willing or able to contribute toward your children’s college expenses. How much is enough? This is highly personal decision: On the one hand, you want to empower your kids to get an education without their taking on crushing debt. High levels of debt without accompanying high incomes and a well-thought-out strategy to pay down the student loan can lead to delayed economic development. This could impact your child’s timeline for marriage, home purchases or even starting a family. On the other hand, you as a parent should consider your other goals before committing financially to college funding. Remember that your child can take out a loan for college, but no one will lend you money for retirement. Your own financial security must be considered while saving for your child’s education.
Last, with the career earning-power figures you’ve gathered, evaluate some other educational options that might carry a lower price tag, such as trade schools, apprenticeships, military service or community colleges, and estimate the ROI of taking those paths also.
2. Begin with the end in mind
This step involves researching college costs, both at public, in-state schools and at private institutions. It helps to use a college planning calculator. Let’s walk through a hypothetical example of how parents might decide how much they need to save for college using this method.
We’ll use two scenarios: A public in-state university like the State University of New York (SUNY) at Binghamton and a private institution such as New York University (NYU) in New York City.
For SUNY-Binghamton, the current annual cost is about $10,000 per year. By the time your small child is ready to go to college in 2040, it will be about $107,000 for all four years of tuition. In the calculator, we use an average rate of return of about 6.5%, so the investment will start out more aggressive and gradually get more conservative as we near the date the child would need the funds to pay for school. I’d also recommend estimating inflation at 5% a year for this calculation.
The calculator delivers a monthly (or annual) amount that you’ll need to save, based on these figures. In this example, the dollar amount it came up with was about $212 per month to meet cost and saving goals to fund an education for all four years, tuition-only, at SUNY-Binghamton.
In comparison, let’s do a calculation for the private university, NYU. Its total cost for students is $55,000 per year currently – much more than is charged by SUNY-Binghamton. And, not surprisingly, NYU, costly even among its peers, equates to a much larger estimated total cost of education in the future, 18 years from now, of about $570,000. Using the same return assumptions as above, the calculator arrived at the need to save about $1,128 per month to fund the four-year tuition goal for this private school. Pretty sobering to think about if your child is in daycare now, but being able to visualize and prepare for these expenses down the road doesn’t take much effort using a savings calculator.
But what if you have just a few years before your kids head to college? Think about investing in Series I savings bonds from the U.S. Treasury. They’re issued by the U.S. government to protect your money from losing value due to inflation. The interest rates on these bonds are adjusted regularly to keep pace with rising prices. In fact, the initial interest rate on a new Series I bond right now is 9.62% (through October 2022). That’s a very nice return, considering you’re taking no risk. And there are even some tax advantages to Series I bonds. In addition, Series I bonds are exempt from state and local taxes, which makes them an even better low-risk investment for savers who live in high-tax states and cities.
3. Understand different ways to save
Lots of positive things can be said about 529 plans for education saving, but I’d primarily promote the “Tax Trifecta” that they offer. The first aspect of that trifecta is tax-deductible contributions. So if you’re a New York state taxpayer, for example, and an account owner of a New York 529 plan, you may be able to deduct up to $5,000, or $10,000 if you’re married filing jointly, from your state income tax bill annually. There are no federal tax deductions for contributions to 529 plans, but other states, including New Jersey and Connecticut, also offer slightly different deductions than New York, for instance. Be aware, for instance, that in New Jersey, one caveat is that taxpayers can only receive the deduction if their household income is less than $200,000.
The second big plus of 529 plans is tax-free growth. So any dividends, capital gains and interest earned is not taxable to you in the year that is earned. And the third advantage is tax-free withdrawals for qualified tuition expenses. Your child can attend any higher-education institution, not just a four-year college or university, and this can include vocational schools or trade schools and even graduate schools after their four years of undergraduate study.
Some further advantages to 529 plans that appeal are that, unlike other types of savings accounts, a 529 plan is generally considered part of the parent’s assets, not the child’s. So it will have much less impact when it comes to financial aid eligibility. And if your child doesn’t use the money in the account, you can choose another eligible family member, such as one of your other children, or even yourself to be the beneficiary without paying any sort of penalty. And, effective Jan. 1, 2020, after the passage of the federal Setting Every Community Up for Retirement Enhancement, or SECURE, Act, student debt repayment and registered apprenticeships can now be considered a qualified expense for a 529 plan.
Are you wondering how much you will actually save from a $10,000 contribution to a 529 plan? If you live and practice in New York state, where the top tax rate is 9.65%, for example, on that $10,000 contribution, you’ll save $965. So almost a thousand dollars is saved just from contributing the funds to the plan, and then you can turn around and use them in the same year that your child needs the funds.
Other options for building college savings during your child’s lifetime include a custodial account under the Uniform Gifts/Transfers to Minors Act (known as UGMA and UTMA accounts, more on these below), tax-free Roth Individual Retirement Account (IRA) account withdrawals, investing in a regular brokerage account or perhaps using a Coverdell Education Savings Account (ESA), for lower-income individuals.
An Altfest financial advisor would be happy to discuss the details of these plans and which, alone or in combination, suits your family’s college savings needs.
4. Understand different contribution methods
Again, the specifics of how each of these savings plans or methods would work for you are unique, but it’s helpful to understand the rules and implications of contributing monthly or perhaps large annual sums to 529 plans, as one example. An advisor also can help you understand the ramifications for your lifetime gift tax exemption of a sizable contribution.
How do you decide how much to contribute to each account? We use a three-step process, where the first step is deciding on what the end goal is, in terms of fully or partially funding your child’s expenses, then establishing how much money you’re comfortable setting aside for solely educational purposes. Last, consider the tax benefits and aggregate contribution limit of the 529 and use those as your guidelines for that method.
5. Think holistically about the education plan
This last suggestion calls for some creative thinking. For example, consider ways a grandparent interested and able to contribute to your child’s college expenses can get involved. For one, they could use the annual gifting method to put money into the future college student’s 529 plan, which would get the money out of their estate to minimize taxes upon death while the 529 contribution also would protect the sum from creditors, who can’t make a claim against the money saved there.
For people with significant financial worth – and tax liabilities – who are preparing for children’s college expenses, it may be worth considering establishing a custodial account such as the UGMA and UTMA accounts for this savings goal. These accounts allow you to hand down assets that would need a trust otherwise. This can include things like art, patents, royalties, real estate or securities. You don’t need a trust or a guardian with these accounts, all you’d need is custodian who acts as a fiduciary for the child, and then they get the proceeds at the age of majority, which varies by state.
With a UGMA or UTMA account, the great thing is that you can remove assets from your estate and any income that these assets generate is going to be taxed at the child’s rate, which in most scenarios is lower than the parents’ rate. But the cons are also pretty obvious, in that it’s going to negatively impact the student’s potential for financial aid because the trust is recorded as their asset, to be used to pay for college. It’s also not usually wise to grant a large account to an 18-year-old, so caution is advised with this option.
Why use one of these accounts versus a 529 plan or a traditional brokerage account for college savings?
Briefly, it’s important to understand that with a 529, you’re gifting cash and then investing it in securities, while UGMA or UTMA accounts can hold other things like real estate or business interests or royalties. If this fits your scenario, you could, for example, give some shares from your medical or dental practice that’s set up as an S corporation to your child through this trust vehicle so they can benefit from the income for their education without having access to or a tax burden from the actual shares.
Another idea we sometimes find appropriate for clients is setting up a “HEET Trust,” which is short for a Health and Education Exclusionary Trust. Briefly, it’s a dynasty trust set up to pay medical and tuition expenses for people two or more generations below the grantor, meaning the person setting up the trust. And usually the overarching idea is also to seek an exemption via the trust from the burden of what’s called a generation-skipping transfer tax (GST) while conveying assets to the generation after your own children for these college expenses.
Finally, you might want to look into a simpler, more straightforward way to think holistically – using insurance to protect the savings for the college bill. If you use the earlier calculation for college savings that I suggested, then you’ll know exactly how much life insurance you need to negate the potential negative impact that premature death can have on your family’s ability to save for college. It’s a situation in which low-cost, term life insurance can be extremely valuable in making the education plan secure and complete, in the worst-case scenario.
Find out more
These ideas are just an introduction to the many avenues that clients can take to meet today’s challenge of higher-education costs.
Learn more about how Altfest’s advisors might be able to help you shape a strategy to start planning for college costs. If you have specific questions or concerns about your family’s situation, please book some time for a complimentary consultation.