College Funding Thoughts
There are at least four ways commonly used to plan for college funding. In this article I will explain the different approaches and review the impact on taxes and financial aid for the student.
The first way most people think of is the 529 Plan – so named for the section of the tax code that created this type of account. The sole purpose of a 529 Plan is to provide tax free growth of funds for higher education. Deposits to the 529 Plan can be lump sum or periodic. The money is placed with an investment firm chosen by the state to manage the investments. Withdrawals are tax free if used to pay higher education expenses of the beneficiary; withdrawals for other purposes will be subject to the penalty provisions of the tax code. All funds must be withdrawn by the time the beneficiary reaches age 30. The full balance of the 529 Plan counts against the student in financial aid calculations. This is a single purpose plan. If your student does not go to college, then you may be forced to take withdrawals and pay tax penalties. By using a 529 Plan you give up liquidity, access, and control of your money. This can be a good savings vehicle, but in my opinion, it is not the best way to save for college.
A second type of account that could be used would be a joint account with a minor under the provisions of the Uniform Gift to Minors Act, either UTMA or UGMA. The account is established in the (minor) student’s name with usually a parent being the adult Trustee. The Trustee controls the account until the student reaches the age of majority, either 18 or 21 depending on the state law. At that point the student has control of the account to use as he or she chooses. Deposits can be lump sum or periodic. The account can be established as a bank account or investment account. The earnings are taxable to the student in the year earned, if they are required to file a return. There is no tax on withdrawals and no requirement to withdraw funds by a specific date. The full balance in the account counts against the student in financial aid calculations. This account is more flexible than a 529 Plan in that it can be used to fund any type of financial need for the minor. The adult trustee controls the account; thus you are not giving up liquidity, access or control, at least until the student reaches the age of majority.
A third way is to keep the money in the parents’ name, perhaps in a separate account designated but not restricted for the student’s use. The parents pay taxes annually on the earnings and maintain full liquidity, access, and control. The account is considered the parents asset and thus only about one third of the balance is considered in financial aid calculations.
The fourth way, and the one I would suggest, is to use a specifically designed whole life insurance policy on one of the parents. This option can have endless variations intentionally designed around your specific needs and plans. Payments can be lump sum or periodic. Cash withdrawals in the form of loans against the cash value are not taxable and can be used for any purpose. The loans do not have to be repaid, but I suggest you at least pay the interest each year. The policy should be designed to build cash value as such a rate that there is sufficient liquidity in the policy for the cash value to be used to fund anticipated college expenses. Cash value in insurance policies is not included in the financial aid calculation. A significant benefit that is not offered by the other options is that the financial need of the student is fully funded in the event of the parent’s disability or premature death. You keep liquidity, access, and control of your money.