College/Savings for Kids (US)

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Biscuits and Gravy
Posts: 83
Joined: Thu Aug 06, 2020 1:38 pm

College/Savings for Kids (US)

Post by Biscuits and Gravy »

I looked back a few years for similar posts and didn't see exactly this information, so I thought I'd share, as I spent most of the morning researching. This is specifically for the United States. Information mostly came from IRS Publication 970, "Tax Benefits for Education" (2020). I was researching this because I have two kids, ages 1 and 3, and am looking for an equitable way to save for their future/education with my ex. The whole not-married thing throws another wrench into the equation, as evidenced mostly in the section on FAFSA.

High-Yield Savings Account or Money Market Account
APY ~.5%. Can use FV equation in Excel to calculate future value or this handy online calculator: ... -tool.aspx
Positives: For a divorced couple, could jointly manage the account and lay out restrictions in the divorce decree for usage and distribution of funds. Stable, FDIC-insured, funds don't have to be used for higher education, no contribution limits.
Negatives: Very low ROI, interest earned is taxable, MMAs frequently have limited transaction privileges, sometimes fees, listed as owner asset on FAFSA.

Custodial Accounts under UGMA/UTMA
UGMA=Uniform Gift to Minors Act; UTMA=Uniform Transfer to Minors Act
This represents an irrevocable gift to the child and cannot be transferred to another beneficiary. The child will gain rights to the account once they reach legal age (in Texas it is 18 for UGMA and 21 for UTMA). The custodian of the account can initiate withdrawal for the benefit of the child for legitimate needs.
Positives: Funds are not restricted to higher education, no contribution limit (although annual gift limit of $15,000 should be kept in mind), earnings and gains are taxed to the minor (federal child tax rate is 10%).
Negatives: Will count as student's asset for FAFSA, which can reduce student's aid package by 20% of account value.

Qualified US Savings Bonds
Series EE and I bonds may be redeemed federally tax-free for qualifying education expenses IF your MAGI (modified adjusted gross income) is less than $93,750 (individual) or $153,550 (married filing jointly) and your filing status is not married filing separately. Maximum investment allowed is $10,000 per year, per owner, per type of bond. Interest exclusion is gradually reduced starting at $82,350 for individuals and $123,550 for married filing jointly.
This could work if I retire before the kids go to college, otherwise my MAGI as an individual will be too high.

529 Plans a/k/a Qualified Tuition Program
Established and maintained by states and eligible educational institutions. Some states provide tax benefits for contributing to a 529 (Texas does not). You can participate in any state's 529 plan, regardless of your residency. Balances are not supposed to "exceed the expected cost of the beneficiary's qualified higher education expenses," but it's a high cap (can exceed $500,000). Withdrawals can be used for higher education and up to $10,000 per year for K-12 tuition. Considered an asset of the account owner for FAFSA.
Positives: No income restrictions and no contribution limit (although, again, $15,000 annual limit for gifts), anyone can contribute (grandparents), unused funds can be rolled over to another beneficiary (younger sibling).
Negatives: The owner can choose to make non-qualified distributions; nothing prevents the owner from draining the account (trust issues for divorced parents; restrictions could be laid out in divorce decree?). Earnings are subject to income tax and 10% withdrawal penalty if not spent on qualified educational expenses. If you have a loss on your investments in your 529, the loss cannot be deducted on your income tax return.
If the custodial parent and owner of the 529 gets remarried, a prenuptial agreement should be made stating any 529 plans are and shall remain assets of their respective owners, otherwise 529 plans may be considered marital assets to be divided in the event of divorce.

Coverdell Education Savings Account (ESA) f/k/a Education IRA
Contributions are not deductible, but amounts deposited grow tax-free until distribution. Distributions will be tax-free if they are not more than the beneficiary's adjusted qualified education expenses for the year. MAGI must be less than $110,000 for individual or $220,000 for married filing jointly to establish and contribute to a Coverdell ESA. Contribution limits will be gradually reduced starting at $95,000 (individual) and $190,000 (married filing jointly). (See IRS Worksheet 7-2).
Positives: Tax-free withdrawals to pay for qualified higher education expenses and also K-12 expenses. Counted as a parent asset on the FAFSA. Can contribute to a 529 and a Coverdell in the same year. Can roll over, tax-free, to another Coverdell ESA for the benefit of the same beneficiary or a member of the beneficiary's family who is under 30. Designated beneficiaries can be changed with no tax consequences.
Negatives: Contribution limit of only $2,000 annually (you can have multiple Coverdells and multiple people can contribute, but contributions to all cannot add up to more than $2,000; excess contributions are subject to a 6% excise tax). Contributions must be made before the beneficiary turns 18 and the account must be distributed in full before they are 30. If you have a loss on your investment, it can't be deducted on your tax return.

Roth IRA
Can withdraw contributions tax-free if needed for child expenses before higher education (braces, big trips, surgeries?). Normal 10% early withdrawal penalty on earnings is waived when funds are spent on qualified higher education expenses. Taxes may still be owed on at least part of the amount distributed.
Positives: Retirement accounts are not counted as assets on the FAFSA. If kid never goes to college, hey, more retirement money for you.
Negatives: Maximum contribution is only $6,000/year. Withdrawals from a Roth IRA to pay for college is counted as base-year income on the FAFSA.

FAFSA for Divorced Parents
Only the custodial parent (parent with whom the child lived the most or, in cases of 50/50 custody, the parent who provided the most support) is required to file the FAFSA. May be beneficial to have the custodial parent be the parent with lower income/assets so the child can qualify for more aid. If custodial parent is remarried, the income and assets of the new spouse must be reported.
529 plans owned by the NON-custodial parent are NOT reported as assets on FAFSA and any distributions count as untaxed income to the beneficiary, which reduces aid eligibility by as much as half of the distribution amount (the same treatment for grandparent-owned 529 plans).

If y'all know of more vehicles, feel free to add. I have no opinion on which is the best, as it largely depends on your individual timeline and whether you think the world and higher education will even be here in 10 years. Personally, I was using my Roth IRA as the college fund, but that was pre-divorce. Post-divorce I have no idea how to make that work equitably, so I'm looking for alternatives.

Laura Ingalls
Posts: 455
Joined: Mon Jun 25, 2012 3:13 am

Re: College/Savings for Kids (US)

Post by Laura Ingalls »

The current version of the FAFSA rules is you use the parent providing the most support (period). I think thinking much about it this yearly in the game is semi-fruitless. College funding is going to change in next 15-20 years. How exactly I refuse to make any wild guesses.

Biscuits and Gravy
Posts: 83
Joined: Thu Aug 06, 2020 1:38 pm

Re: College/Savings for Kids (US)

Post by Biscuits and Gravy »

Ah, thanks for the FAFSA clarification. I largely agree with you about preparing this early being semi-fruitless, which is why I liked the Roth IRA approach. If the kids don’t go to college or college is free or we live in a Mad Max dystopia then at least it wasn’t all tied up in a 529.

Posts: 457
Joined: Mon Aug 14, 2017 3:49 pm

Re: College/Savings for Kids (US)

Post by ZAFCorrection »

That's really interesting information, particularly about the roth IRA. I did not know that was possible. It takes me back to figuring out how I was going to pay for undergrad.

Posts: 146
Joined: Thu May 16, 2019 6:51 pm

Re: College/Savings for Kids (US)

Post by Qazwer »

For Roth and FAFSA - remember that you do not file FAFSA during 4th year - so income can be higher that year and no more impact

For 529 $15000 annual gift limit per child per donor and then just limits life time gift limit (not directly taxed) - can also lump together years as long as you file with IRS and not exceed life time gift limit up to 5 years at once / so can put in 15*5=75 as long as no more gifts for next 5 years
Check out Fidelity plans with low ER in a few states if you go that route

Given benefits of Roth - if you are not already maxing IRA (both kinds of limit go together) makes sense usually to max out those first

For ERE types the penalty for early withdrawal can be less than difference in tax rates when working vs retired so a 401k could also be considered depending on planned tax rates

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