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Funding Your Kid’s College Education

Graduate hugs parentsOur oldest daughter, Maeve, is a senior at Falmouth High. So Jill and I are in the thick of college discussions, tours, applications, the teenage drama, and of course, how to pay for college.

It is crazy how higher educational costs continue to spiral out of control. The average published annual in-state tuition and fees at public universities in the U.S. rose to $10,230 in 2018, according to the College Board, which also reported that private four-year schools raised their tuition and fees to an average of $35,830 for 2018. And folks, this does not even include room and board.

We all understand how crucial a good education is to our children’s future, and the good news is that a lot of us are doing the right thing. I recently read a Fidelity report that said last year 72% of parents polled had started saving, compared to just 58% the first year they did their research. That’s the good news.

But despite their best efforts, parents often fail to meet their own savings goals. In fact, parents polled by Fidelity said they are ultimately able to cover less than half of what they expected. Parents who planned to fund 70% of their children’s total college costs were only able to cover 29% by the time their children reached college age.

Hmmm . . . we have a problem.

You see, while good intentions push you in the right direction to save for your children’s education, good intentions certainly are not an investment strategy. So, this week let’s talk about how to find an appropriate approach to meet your future financial needs and why it should be a crucial part of your college education funding plan.

One enormously popular method for saving for college is the 529 college savings plan. Student loan company Sallie Mae reports that 529 plans now account for 30% of all college savings, more than any other savings tool.

These plans are available in almost every state in the country, and Massachusetts is no exception. Two programs are available in Massachusetts: the U.Fund, a 529 savings plan managed by Fidelity Investments using Fidelity’s mutual funds, and the U.Plan Prepaid Tuition Program, offered by the Massachusetts Educational Financing Authority, or MEFA. And while I’m outlining some of the details of the plans here in Massachusetts, it’s worth noting that you can open a 529 plan in any state (except Wyoming).

Like all 529 plans, those offered in Massachusetts offer some tax advantages. Any earnings are tax-deferred, and distributions are also tax-free when used to pay qualified educational expenses such as tuition, fees, room and board, books, and supplies. What’s more, account holders can claim a Mass. state income tax deduction ($1,000 for individuals, $2,000 for married couples filing jointly).

The money from a U.Fund account can be used at accredited colleges and universities nationwide. And thanks to the tax law passed at the end of 2017, as of January 1st, you can also use U.Fund money to pay for elementary and secondary school tuition (up to $10,000 per calendar year).

The U.Plan Prepaid Tuition Program helps to lock in tuition and mandatory fee costs at schools here in Massachusetts. Both public and private universities participate in the Program. Your child doesn’t have to choose a school until it’s time to go to college, and if your child elects to go to a non-participating school (or doesn’t go to college), your investment is returned with interest (and no penalty).

Anyone can open a 529 plan regardless of income. There are no annual contribution limits, though the IRS views contributions made to a 529 plan as a gift for tax purposes. This year that gift tax exclusion is $15,000 per individual. A special gifting feature of 529 plans enables individuals to contribute up to $75,000, pro-rated over five years.

There are some downsides to 529 plans. They are paired with specially chosen and managed investments, so I find that you don’t have the flexibility and risk mitigation tools you may have with other types of investment accounts. Also, if you need to withdraw money from a 529 plan to use for non-qualified expenses, you face paying income tax and a 10% penalty on any earnings.

Also, bear in mind that the Free Application for Federal Student Aid (FAFSA) considers the value of 529 plan savings owned by either dependent students or their parents when determining eligibility. It’s important to work with a financial professional to make sure that whatever potential reduction in federal student loan assistance you may receive is offset by the tax-free investment gains you’ll realize.

In find that there’s often an overlooked investment instrument that can be used to pay for college education: The Roth IRA. While Roth IRAs were originally intended to help people save for retirement, Roth IRAs can also be used to pay for higher educational costs.

In fact, Roth IRAs work similarly to 529 savings plans. You put your money in after taxes and your savings grow tax-free. Presuming you follow the rules, you won’t owe taxes on investment earnings in either account.

Roth IRA earnings and withdrawals are tax-free after you reach age 59 ½, but they can also be used before then without incurring a penalty to pay for qualifying higher education expenses.

In my opinion, Roth IRAs provide investors with much more flexibility than 529 plans when it comes to making your money work for you. You see, Roth IRA’s are not tied to a limited set of investment options like 529 plans. Many Roth’s will implement risk mitigation strategies designed to help sidestep large market losses.

Roth IRAs do come with their own set of restrictions and limitations to be aware of. Individuals with a Modified Adjusted Gross Income (MAGI) of $120,000 or less and couples filing jointly with a MAGI of $189,000 or less can contribute a maximum of $5,500 per year. Individuals with incomes of $135,000 or greater ($199,000 for couples) are ineligible to contribute. And while Roth accounts aren’t calculated as assets on the FAFSA, money taken from a Roth to pay for school will be counted by the FAFSA as untaxed income. That can potentially affect financial aid eligibility.

Pre-paid tuition plans, 529 savings plans, and Roth IRAs – all of this can be overwhelming, I get it. And more than one of these options may yield the best results for you. That’s why it’s important to work with a financial professional to make sure you’re making the best possible decisions. After all, higher education is arguably the most significant investment you will make in your child’s future. While careful planning and implementing an appropriate strategy can help to meet your child’s educational needs and prepare them for the rest of their lives, I only wish I could find a plan that would address teenage drama.

Be vigilant and stay alert because you – and your children – deserve more.

Have a great week.

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at jeff@old.cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.

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