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College Planning

Why Wouldn’t You Use a 529 Plan to Save for College?

By College Planning

529 plans are a powerful tool for building college savings, yet many worry that 529’s are too restrictive – that the money they put in could be “lost” somehow if the child gets a sports or academic scholarship, or chooses not to go to college at all.

Fear not! You have options.

First, you can always withdraw the money that you contributed penalty- and tax-free. Second, if Junior earns a sports or academic scholarship, you can take money out of the 529 plan up to the dollar amount of the scholarship penalty-free.

There is a small catch. When you take a distribution from a 529, the IRS will consider a portion of that to come from “contributions” and another from growth or “earnings.” The latter part will be taxed as ordinary income. So how does the IRS figure out what portion comes from earnings v. contributions?

It’s just a simple ratio. Let’s say you’ve contributed $500 per month to Junior’s 529 from the time he was born and used one of those “age-based” investment options the plan offers. Initially, the account was invested 100% in stocks but over time it’s shifted to mostly bonds and CDs. By the time he’s 18, the account has grown to $177,207. Of that, $108,000 (or 61%) represents money contributed while $69,207 (or 39%) represents earnings in the account.

So, say Junior gets a scholarship worth $25k his Freshman year. If you take $25,000 from his 529, 39% of that – or $9,750 – will be considered earnings and be taxed as ordinary income. Had you invested in a traditional brokerage account, instead of Junior’s 529, would you have come out ahead? Multiple factors come into play. Were your gains in the traditional brokerage account short-term in nature and taxed as ordinary income? Given changes to the tax code over time and your own career trajectory, how have your personal tax rates changed? Using some pretty middle-of-the-road assumptions, my quick calculations show it to be a wash.

Another option is to leave the funds in the 529 plan and let them grow until your kids’ kids are old enough for college. You can always change the beneficiaries of a 529 account and there is no deadline by which you have to use the funds. This makes 529s a great vehicle for creating what amount to educational trust funds for future generations.

Given all of that, it doesn’t make sense not to use a 529 to save for college.

529 Plans Are Powerful Tools For Building College Savings

By College Planning

There are no income restrictions limiting who can open a 529 plan. You can contribute up to $15,000 annually to a given child’s 529 without triggering gift tax. Those who are fortunate enough to have $75k to invest can make five years’ worth of contributions in one go, gift tax free.

Plans offer low-cost, “age-based” investment portfolios. Initially, they’ll be invested 100% in stocks. Over time, bonds get added to the mix, until the accounts hold just bonds and CDs when the child reaches 18. Funds grow tax-free, and, so long as distributions are used for qualified expenses, they will also be free of tax. “Qualified expenses” include:

  • Tuition and mandatory fees.
  • Room and board during the academic year, up to the maximum given in the university’s financial aid calculator or the amount actually charged if the student is living in university-operated housing.
  • Books, supplies and equipment.
  • Expenses to address special educational needs.
  • Computers, software and internet service.

There are some expenses students face that are not considered “qualified expenses,” namely:

  • Health insurance payments.
  • Expenses and fees related to sports teams and health clubs/gyms.
  • Electronics and smart phones.
  • Travel to/from campus and local transportation expenses.

When opening a 529 account, you are not required to invest in your own state’s plan. That said, more than thirty states give their residents tax incentives to stay in state. Find out who and how much in this chart.

A handful of states are so generous as to give their residents tax breaks for investing in any state’s 529 plan. Find out who and how much here.

So, given all of the above, why are some parents – and, in my experience, especially grandparents – reluctant to use 529’s? I’ll get to that in my next post.

States That Give Their Residents Tax Incentives to Invest in Any State’s 529 Plan

By College Planning
State Tax Incentive Link to State’s 529 Plan
Arizona Contributions to any state’s 529 up to $2k (single), $4k (MFJ) are deductible www.az529.com
Missouri Contributions to any state’s 529 are deductible up to $8k (single), $16k (MFJ) www.missourimost.org
Montana Contributions to any state’s 529 are deductible up to $3k (single), $6k (MFJ) www.achievemontana.com
Pennsylvania Contributions to any state’s 529 plan of up to $15k per done/beneficiary can be deducted from taxable income www.pa529.com

States That Give Their Residents Tax Incentives to Use Their Own State’s 529 Plan

By College Planning
State Tax Incentive Link to State’s 529 Plan
Alabama Contributions to Alabama’s 529 are deductible up to $5k (single), $10k (MFJ) www.collegecounts.com
Arkansas Contributions to Arkansas’ 529 are deductible up to $5k (single), $10k (MFJ) www.arkansas.529.org
Colorado Any dollars invested in Colorado’s 529 are deductible to the extent of taxable income www.collegeinvest.org
Connecticut Contributions to Connecticut’s 529 are deductible up to $5k (single), $10k (MFJ) www.aboutchet.com
Dist. of Columbia Contributions to DC’s 529 are deductible up to $4k (single), $8k (MFJ) www.dccollegesavings.com
Georgia Contributions of up to $4k per beneficiary (single filers) and up to $8k per beneficiary (MFJ) to Georgia’s 529 are deductible www.path2college529.com
Idaho Contributions to Idaho’s 529 are deductible up to $6k (single), $12k (MFJ) www.idsaves.org
Illinois Contributions to llinois’ 529 are deductible up to $10k (single), $20k (MFJ) www.brightstart.com
Indiana Indiana residents can receive a 20% state income tax credit on up to $5k contributed to the Indiana 529 plan www.collegechoicedirect.com
Kansas Contributions of up to $3k per beneficiary (single filers) and up to $6k per beneficiary (MFJ) to Kansas’ 529 are deductible www.learningquest.com
Louisiana Contributions of up to $2,400 per beneficiary (single filers) and up to $4,800 per beneficiary (MFJ) to Louisiana’s 529 are deductible www.startsaving.la.gov
Maryland Contributions of up to $2,500 per beneficiary Maryland’s 529 are deductible www.maryland529.com
Massachusetts Contributions of up to $1k (single filers) and up to $2k (MFJ) to Massachusett’s 529 are deductible (at least thru 2021 tax yr) www.fidelity.com/529-plans/massachusetts
Michigan Contributions to Michigan’s 529 are deductible up to $5k (single), $10k (MFJ) www.misaves.com
Minnesota Residents can choose whether to invest in another state’s 529 and take a tax deduction of $1,500 (single) or $3,000 (MFJ) orreceive a tax credit of up to $500 for contributions made to Minnesota’s plan subject to an AGI phaseout of $75k www.mnsaves.org
Mississippi Contributions to Mississippi’s 529 are deductible up to $10k (single), $20k (MFJ) www.treasury.ms.gov.collegesavingsmississippi
Nebraska Contributions to Nebraska’s 529 are deductible up to $5k (single), $10k (MFJ) www.nest529direct.com
New Mexico Contributions to NM’s 529 are fully tax deductible www.nmetb.org
New York Contributions to New York’s 529 are deductible up to $5k (single), $10k (MFJ) www.nysaves.org
North Dakota Contributions to North Dakota’s 529 are deductible up to $5k (single), $10k (MFJ) www.collegesave4u.com
Ohio Contributions of up to $4k per child to the Ohio 529 are deductible www.collegeadvantage.com
Oklahoma Contributions to Oklahoma’s 529 are deductible up to $10k (single), $20k (MFJ) www.ok4saving.org
Oregon Contributions of $150 (single) or $300 (MFJ) to Oregon’s 529 receive a tax credit www.oregoncollegesavings.com
Rhode Island Contributions to RI’s 529 are deductible up to $500 (single), $1k (MFJ) www.collegeboundsaver.com
South Carolina All contributions to the SC 529 are tax deductible www.futurescholar.com
Utah Contributions to the Utah 529 of $2,040 (single) and $4,080 (MFJ) are eligible for a 5% state income tax credit www.my529.org
Vermont Contributions to Vermont’s 529 of up to $2,500 (single), $5,000 (MFJ) are eligible for a 10% Vermont income tax credit www.vheip.org
Virginia Contributions to Virginia’s 529 of up to $4k per beneficiary per year are tax deductible www.virginia529.com
West Virginia Contributions to West Virginia’s 529 are fully tax deductible www.smart529.com
Wisconsin Contributions to Wisconsin’s 529 of up to $1,670 (single) and up to $3,340 (MFJ) per beneficiary are fully tax-deductible www.529.wi.gov

Financial Aid Strategy for Small Business Owners

By College Planning, Financial Planning

If you own a small business with fewer than 100 employees, here is something to consider to improve your eligibility for financial aid. Public universities use the FAFSA to collect information about your income and personal, non-retirement assets. They place a zero value on family businesses that employ fewer than 100 people. Don’t be offended – this is actually a good thing!

The FAFSA will ask for your income for the prior two calendar years, as reported on your 1040. They will ask you for the value of your various personal, non-retirement assets – checking, savings accounts and brokerage accounts – on the date the FAFSA is filed (generally, the autumn of your student’s senior year of high school). Small business owners can take advantage of these facts to loan their small businesses money from their personal accounts prior to completing the FAFSA to remove those dollars from the FAFSA, lower their family’s Expected Family Contribution and raise their eligibility for financial aid.

Following Divorce, Who is the “Parent” for Financial Aid Purposes?

By College Planning

The financial aid process is a little more complicated when a student’s parents are divorced. Who is considered the “parent” for financial aid purposes?  The answer differs based on whether you’re applying to a public university that uses the FAFSA or a private institution that uses the CSS.

Let’s start with schools that use the CSS because it’s simple and straightforward. Colleges consider both Mom and Dad – or both Moms or both Dads – to be “parents” for financial aid purposes. They also consider stepparents to be “parents.” They will look at the income and assets of all of them. They’ll examine retirement assets, annuities, home equity and small business assets – basically everything. (The one exception remaining is any cash value you may have in a whole life insurance policy.) Many private institutions have healthy endowments, so they still may award aid to students – but they want to paint a complete picture of all of the resources at a student’s disposal before reaching a decision on aid.

For schools using the FAFSA, who is a “parent” for financial aid purposes is more complicated.

First, parents whose divorce is not yet finalized as of the date the FAFSA is filed are still considered married for financial aid purposes, and the income and assets of both parents will be examined. Second, if a student’s parents live together – regardless of their marital status – the FA office will consider the income and assets of each.

Now, if a student’s parents are divorced, the one who is considered the “parent” for the FAFSA is the parent with whom the student lived the most in the last twelve months. If custodial time is split evenly, the parent who provided more financial support in the last twelve months is the “parent” for the FAFSA – even if that means only $1 more. (Note, it doesn’t matter which parent gets to claim the student as a dependent on their tax return.) The school using the FAFSA will then examine the income and assets of the one “parent” when determining financial aid. And, as for married parents, they will exclude from assets any retirement accounts, equity in your primary residence, annuities and the cash value in whole life insurance policies.

If, however, this “parent” has remarried, the school will also look at the income and assets of the stepparent. Fun fact. Knowing how the FAFSA ensnares stepparents, many divorced parents of high school and college aid children who are in relationships choose to delay getting married until the kids are in their final year of college!

Why Outside Scholarships Will Actually Reduce Your Financial Aid

By College Planning

Let’s say your guidance counselor tells your high schooler that she should find an “outside” scholarship – one offered by a foundation or other group rather than a college financial aid office. Often these scholarships are targeted at students who meet a specific set of criteria. For example, a San Francisco Bay Area family foundation offers $5,000 scholarships to local students who have good grades and 50% or more Filipino ancestry. Another offers awards to students who are African-American and want to study business. These are indeed great opportunities to gain “free money” for college.

But here’s the catch. If your student receives a $5,000 outside scholarship, your expected family contribution will not go down by $5,000. Instead, the college she ultimately attends will reduce her financial aid offer by $5,000. To illustrate:

 

Before Outside Scholarship After Outside Scholarship
Cost of Attendance $50,000 $50,000
Expected Family Contribution*  (20,000)  (20,000)
Student Need 30,000  30,000
Financial Aid ** $30,000  30,000
     less Outside Scholarship (5,000)
Revised Financial Aid ** $25,000
What Your Family Pays (aka the “Net Price”) $5,000

* As determined by every institution but following certain guidelines.

** Package can include grants/scholarships, work-study and loans.

 

So before you spend a lot of time and energy chasing outside scholarship money, visit the College Board’s website and use their tool to get an idea of what your family may be expected to contribute to college costs: https://bigfuture.collegeboard.org/pay-for-college/paying-your-share/expected-family-contribution-calculator. Use another of their tools to further estimate the “net price” that a specific college or university could expect you to pay: https://bigfuture.collegeboard.org/pay-for-college/tools-calculators. If you discover that you’ll probably be expected to contribute the at or near the full amount of a college’s cost of attendance, then time devoted to searching out and applying for outside scholarships can be well worth it.

Who Owns an Asset Impacts Financial Aid – Part 2

By College Planning

In my last post, I explained that financial aid officers will treat assets owned by the parent and the child differently for the purposes of calculating a family’s “expected contribution.” Now let’s consider savings set aside for Junior’s college by his grandparents.

The financial aid officers will ignore them.

Yes, you read that right.

But here’s the catch. Colleges look back at the two prior years of income when calculating aid for the next year. If the grandparents take a $10,000 distribution from the 529 they’ve created for Junior in his freshman year, that $10,000 will be considered income to Junior in that year and a college will assess that income at 50% his second year. When determining financial aid for Junior’s sophomore year, your family’s expected family contribution will then go up by $5,000.

You don’t want that to happen. So here’s what you do. Wait to use 529 plan savings from the grandparents until the last year or two of Junior’s college, to minimize the impact on your family’s expected contribution.

Who Owns An Asset Impacts Financial Aid – Part 1

By College Planning

Who owns an asset – meaning the child, the parent, a grandparent or some other wealthy benefactor – can significantly impact how much of that asset a college’s financial aid office expects you to contribute to paying college costs. Let’s explore how and why.

Say you’ve saved $100,000 for your child’s college education by the time she’s a high school senior.

Assets that are considered to be owned by you, the parent, are assessed at 5.64%. This will include funds held by you in checking, savings and traditional/taxable brokerage accounts, and – good news – 529 plans, even if they are nominally owned by your child. Of that $100,000 you’ve saved, a college will expect that $5,640 be used to pay for college each year.

On the other hand, assets that are considered to be owned by the child – like funds held in an UGMA/UTMA – are assessed at a much higher rate – 20%. Of that same $100,000 saved in an UGMA/UTMA, a college will expect you to use $20,000 each year to pay for college.

Can you see what just happened here? The decision about where to save that $100,000 for college – in an UGMA/UTMA v. a 529, just raised your family’s expected contribution, or EFC, by $14,360 each year.

Yikes!

You’re first reaction is probably something along the lines of “No one ever told me….” There’s likely a good reason for that.

For those who’ve been working with a financial advisor

The typical financial advisor is operating under a business model where they make a percentage – usually 1% – of the assets that they’re managing. Since 529 plans are administered by institutional money managers like Vanguard or TIAA-CREFF, a financial advisor can’t profit from them. Savings placed in UGMA/UTMAs, on the other hand, can be included in an advisor’s managed assets, on which s/he earns fees.

Your financial advisor may have told you that 529 plan fees were high, investment plan choices were limited and performance v. traditional mutual funds was difficult to determine. And all of that was quite true in the early days of 529 plans – the late 1990’s and early 2000’s. (Hint: It hasn’t been true for the last decade.)

Your tax professional may have doubled-down on your financial advisor’s advice, since UGMA/UTMAs once enjoyed some beneficial tax treatment.

For those who were “do-it-yourselfers”

You’re off the hook. The financial press was largely echoing the advice that financial advisors and tax professionals were giving. (Hmm, could there be some relationship between what the financial press is touting and what financial advisors are selling? But I digress….)

 What to do now

So you got some bad advice. What can you do now?

Changes to the tax code made in late 2017 severely limited the already small tax advantages given to savings held in an UGMA/UTMA. Greater competition for 529 plan assets over the last decade means that

  • fees have come down drastically, to where a plan using index funds charges about 0.13% in fees;
  • investment options are as broad as they can be; and,
  • performance is transparent.

If you have saved funds in a UGMA/UTMA, all is not lost! You can liquidate the assets held and transfer the cash into a Custodial 529 account that will, ultimately, be considered an asset of the parent for financial aid purposes. You will have to pay tax on capital gains in the UGMA/UTMA, but the savings in financial aid granted should well exceed those taxes.

Next, we’ll explore how you can shelter more college savings in accounts held by grandparents or other wealthy benefactors.

Maximize Financial Aid by Minimizing Your Expected Family Contribution

By College Planning

Parents, our goal is to minimize our Expected Family Contribution so that we can maximize our chance of receiving financial aid.

So, how exactly do we do that?

To determine your Expected Family Contribution, or EFC, a college’s Financial Aid Office will look at income and assets – yours and your child’s. They will weigh income more heavily than assets.

How Income is Treated

Parents will be expected to devote 22-47% of their annual income to college costs. (And, heads up, salary deferrals to employer-sponsored retirement plans and contributions to IRAs, SEPs will get added back into your income.) Students will be expected to contribute more – 50% – of their own earned income. (How’s that for punishing a kid for getting a paid job during the summer or after school? Sheesh!) What’s more, colleges take a two-year “look back” on income, meaning that if you’re applying for financial aid for the 2019/20 academic year, they will look at your and your student’s income in 2017 and 2018.

How Assets are Treated Differs for Public v. Private

Whether a college includes an asset in their financial aid calculations depends on whether they are public or private. Public institutions use a form called a “FAFSA” to collect your financial information. They will include funds saved in bank or brokerage accounts; custodial UGMA or UTMA accounts; 529s and Coverdell ESAs; assets owned by a family business, and investment properties. They will, however,  exclude some assets, including funds saved in 401(k)s, IRAs and other retirement plans; equity in your primary residence; cash values in whole life insurance policies and annuities you’ve purchased. Private colleges use a supplementary form called the “CSS Profile” to collect your financial data. And they basically look at everything.

It’s important to know that who owns an asset also matters when it comes to whether and how that asset gets included in financial calculations. I’ll explain in my next post.