A Closer Look at Funding College Education

College costs continue to rise at a fast pace (5%). For the 2014-15 year tuition plus room and board averaged $43K for private four-year colleges; $33K for out-of-state public colleges; and $19K per-year for in-state public four-year colleges. These numbers are higher for private university programs in California.

When parents, students, relatives or other benefactors ask us how they can help fund a college education we normally outline three conventional ways and also suggest two other ways. The conventional ways are to use a 529 plan (either college savings or pre-paid tuition), a Coverdell Educational Savings Account (ESA), and a Uniform Trust for Minors (either UTMA or UGMA). To cover the non-qualifying expenses we recommend a taxable brokerage account. Finally, once a child has their own earnings (however small) we also recommend a Roth IRA since it can grow tax free. Even so, the most common plan is the 529 plan because it has the highest contributions and no earning limits.

You are mistaken if you think that paying for college is as simple as just buying a tax advantage plan (such as 529 college savings plan) and letting it grow. If you want simplicity you’ll forgo any tax advantage. The complexity arises when you distribute the money to pay for the various types of college expenses.

College expenses can be paid directly to the institution, to the beneficiary student, or to the owner of the 529 plan. The best way is to pay the institution directly but often tracking these types of payments can be difficult. The more common way is to send the money directly to the beneficiary (student) but there would need to be assurances that the payment goes towards “qualifying” expenses or tax reporting penalties and taxes may apply. Last is to distribute the money to the owners (parents, grandparents, or other benefactors). In this scenario, the owners will need to keep records to demonstrate that each distribution has matching beneficiary (student) qualifying expenses.

So, here are some tips to consider when you are ready to pay for college from a 529 plan:

The key to distributing from a 529 plan is that the educational expense must be “qualifying”. To be eligible to withdraw from a college savings 529 plan without incurring the 10% penalty and taxes the beneficiary (student) must be enrolled in a qualified institution. Traditional qualifying expenses include tuition, “qualifying” room and board and expenses directly linked to course requirements. If not qualified the penalty plus taxes on the gain will apply.

We need to be clear that paying off educational loans is not considered a “qualified higher-education expense”. Also be clear that the list of “qualifying” expenses gets continually updated, albeit rather slowly. Only this year are they willing to approve computers as part of “qualifying” educational expense (but do first check that it applies to your plan).

New 529 rules may finally eliminate the penalties if funds are returned to the 529 plan within 60 days (this happens when a student is forced to unexpectedly drop out of college and no longer qualifies to draw from the 529 plan).

Additional issues arise if the child actually qualifies for financial aid. A student with financial aid needs to be particularly careful when they access any nonparental funded 529 plan. The non-parent 529 plans are not part of a student’s financial aid application until the first distribution is made. We recommend that any non-parental 529 be accessed last. If not, a student’s income will be increased by the distribution and will affect the next year’s financial aid by as much as 20%. Parental 529 plans, on the other hand, impact aid by just over 5.5%.

If there are remaining assets in the 529 when the beneficiary ends their education (undergrad and graduate school) then parents need to transfer the named beneficiary to a close relative (who still needs college education funds) or they may transfer ownership to the student if they are likely to be in a lower tax bracket (but they can’t avoid the 10% penalty if they use the funds for non-qualifying expenses).

Finally, funding a child’s college education is important BUT it should never be at the expense of an adult’s own retirement or personal needs. Paying for college has to be in balance with your own financial plan. In addition, a 529 plan requires careful monitoring and reporting. It is a great financial learning opportunity for a student to annually track the 529 budget and file taxes.