With the average cost of a 4-year college education in the U.S. now at $145,744 ($36,436 per year) (Hanson, “Average Cost of College & Tuition”, 2023), advanced planning may be more important than ever. Parents have shouldered much of the responsibility of covering these seemingly ever-increasing costs with many opting to pay (via parental loans, income, savings, etc.) for over half of all college expenses for their children. In fact, parental income and savings alone now cover over 44% of college costs. (Hanson, “How Do People Pay for College?”, 2022). In this post, we will examine the various options available to parents (and grandparents) to cover the cost of higher education most effectively.
A multitude of options exist when it comes to saving for college expenses. Some of the more commonly recognized include: Coverdell accounts, 529 plans, custodial accounts, Roth IRAs and savings bonds. Some strategies may be a better fit than others for high-income earning families that are phased out of contributions to certain accounts. The table below summarizes key features of some of the options that might make sense for high-net-worth families including 529 College Savings Plans, UGMA/UTMAs, and direct payment.
College Funding Vehicles
|529 College Savings Plan||UGMA/UTMA||Direct Payment|
|Contribution Limits||No annual contribution limit; lifetime contribution limits exist and vary by state||No contribution limits exist||N/A – expenses are paid at the discretion of the parent/grandparent|
Tax-free growth and withdrawals if used for qualified education expenses; tax on earnings and 10% penalty upon withdrawal if not used for qualified expenses
Contributions may be deductible at state level
Annual income tax responsibility may be either parent or beneficiary depending on income level
Kiddie tax applies above $2,500 in unearned income
Contributions are NOT tax deductible
|Not held in a particular account, income is taxed normally and has no special treatment|
|Gift Tax Rules||Gift tax applies above annual exclusion amount but can also be “superfunded” with up to 5 years of annual exclusion gifts in one year||Gift tax applies above annual exclusion amount||Direct payment would not be considered a gift for tax purposes|
Higher Education: Tuition, room/board, books/supplies, student loan repayments up to a lifetime maximum of $10,000 per borrower*
K-12 Education only up to $10,000/year*
N/A – funds can be used for anything that benefits the child
The account becomes the beneficiary’s property at the age of majority
N/A – funds can be used for anything that benefits the child if the owner pays directly
Beneficiary does not receive assets at any time, assets are paid directly to education expenses (cannot go to the child without becoming a gift)
|Ownership & Beneficiaries|
One owner and one beneficiary. Owner has control and makes decisions related to contributions, investments, distributions, and beneficiaries
Successor owner can be named, and the beneficiary can be changed to an eligible family member
|Irrevocable gift to the child, custodian manages for the benefit of the child|
One owner, no beneficiary. No gift is made. Owner has control and makes all decisions with their assets – these are not specifically designated for education.
If assets are given to the child, they become a gift and are subject to gift tax.
|Inclusion in Estate||Not included in owner’s estate||Included in custodian’s gross estate until the account becomes property of the beneficiary, then it is included in the beneficiary’s estate||Included in owner’s estate|
|*Qualified expenses at the federal level, but state-specific at the state level|
From a tax perspective, Section 529 plans function similarly to Roth IRAs, but with tax advantages for college education costs as opposed to retirement. Contributions are made with after-tax dollars and grow tax-deferred. If withdrawn for qualified higher education expenses, withdrawals are income-tax free. If withdrawn for purposes other than qualified higher education expenses, any earnings will be subject to ordinary income taxation and a 10% penalty. One unique aspect of 529 plans is the ability to so-called “superfund” accounts. Typically, contributions in excess of annual gift-tax exclusion limits would be subject to gift tax, a form 709 would need to be filed, and a portion of the lifetime exemption would need to be allocated. 529 plan rules allow donors to gift up to five years ($85,000 per individual or $170,000 per couple) of annual exclusion gifts in one year and “spread” the gift over five years for tax purposes. This also allows for a greater amount to be invested earlier and thus the potential for greater accumulation. Another powerful aspect of these plans is that while the owner retains control of the account, the assets are removed from their estate for estate tax purposes. For example, assume grandparents want to help fund college educations for their five grandchildren. The couple could “superfund” 5 years of annual exclusion gifts for each grandchild thus removing $850,000 (plus growth) from their estate. All while simultaneously maintaining control and providing for their grandchildren’s educations. The Secure Act 2.0 added an interesting option for 529 plan funds not used for college expenses. Beginning in 2024, and subject to several restrictions, 529 funds will be eligible for a tax-free rollover to a Roth IRA for the beneficiary of the 529 plan. Qualifying criteria include the following:
- 529 account opened for at least 15 years
- Annual rollover cannot exceed annual IRA contribution limits
- Earnings and contributions made in the previous 5 years are not eligible
- Subject to a $35,000 lifetime rollover maximum
This change provides further flexibility for 529 plan funds and makes the vehicle potentially even more attractive. Further IRS guidance is anticipated prior to 2024.
Other College Funding Vehicles
Some additional plans that are commonly used for college savings include Coverdell Education Savings Accounts, Prepaid Tuition Plans, Savings Bonds, and Traditional or Roth IRAs. These have some benefits but may not necessarily be the best fit given a variety of contribution limits and tax consequences.
|Coverdell Education Savings Account (ESA)||Prepaid Tuition Plans||Savings Bonds||Roth & Traditional IRAs|
|Contribution Limits||$2,000 per beneficiary (annually)|
No contributions allowed after beneficiary reaches age 18 (unless beneficiary has special needs)
|Available to in-state residents, owner purchases “units” or “credits” to effectively lock in the current cost of tuition|
Plans & maximum contribution limits are state-specific
|Tax Treatment||Tax-free growth and withdrawals if used for qualified education expenses|
Tax on earnings and 10% penalty upon withdrawal if not used for qualified expenses
Contributions are not deductible
|Tax-free withdrawals if used for qualified expenses|
Contributions are considered gifts, so gift tax may apply for contributions above the annual exclusion amount
Some states offer tax-advantaged contributions
|If withdrawn prior to age 59 ½ for qualified higher education expenses, the 10% early withdrawal penalty will not apply|
Earnings will still be subject to ordinary income tax upon withdrawal
|Qualified Expenses||Tuition/expenses; full account must be distributed by age 30||Tuition only (some rare exceptions may apply)||Tuition, fees, books, supplies, and other equipment as well as special needs||Tuition, fees, books, supplies, and other equipment as well as special needs|
|Ownership & Beneficiaries||One owner and one beneficiary. Owner has control and makes decisions related to contributions, investments, distributions, and beneficiaries.|
Beneficiary can be changed if certain requirements are met
|Many plans can be transferred to siblings (restrictions may apply)||Owner must be 24 years of age or older to qualify for the interest exclusion||Owner may withdraw to pay qualified educational expenses for self, spouse, children, or grandchildren (who may or may not be beneficiaries)|
|Inclusion in Estate||Generally not included in owner’s estate||Not included in owner’s estate||Included in owner’s estate||Included in owner’s estate|
With the increasing costs of college education, it is prudent to begin planning and saving early and to take into consideration all relevant financial considerations including estate planning, contribution limits, tax planning, costs covered and flexibility. Working with a team of qualified professionals can often help clarify and simplify this decision-making process.