From the Clipboard - The best college savings options? Here’s how to choose.

Jack
09.03.21 08:00 AM Comment(s)

The best college savings options? Here’s how to choose.

I can't believe I've never don a blog, podcast, or video on this topic but recently I've been asked this question a lot. So I guess it's time to share some thoughts on this question:

 

What are the best options for college savings? Or best ways to save for college?

 

A disclaimer: Just remember that this is for informational and educational purposes only. This is not a recommendation to buy or sell anything. You should always talk to your own tax account and/or financial professional for your specific circumstances. Nothing is guaranteed, battery is not included, and your mileage may vary.

 

A number of people have asked me about the best ways to save for college. The answer, of course, always is “it depends”. It depends on how many children you have, their ages, and many other factors to be considered before you start figuring out what type of account or investment is best for you.

 

First step is to answer a couple of questions:

 

What does saving or paying for college mean to you?

 

This may seem like a weird question. If you ask most people and ask them if they want to save for college the answer is frequently yes. But what does that really mean? Just as often, two parents will have completely different ideas in terms of what they actually mean by saving or paying for college. For example, one parent may want to only contribute 50% of an in-state public college for the student to have a stake while another parent may want to pay 100% of a private college to help the student avoid debt. The difference can be over $50k per year!

 

What can you afford to save/pay for college?

 

The most common answer I get is “something affordable” or “I don’t know”. Having some saved is better than having nothing saved, but it's really not an answer. If you're just thinking that you just want to do something, then you should stop listening to this and just go put a dollar into a cookie jar or a bank account. You're done because you did something though most people won't think that that means very much.

 

Who do you want to be the legal owner?

 

This may seem kind of obvious but it does have implications. Often, saving for college means the legal owner of the account is the parent even though the student is the “beneficiary”. That may or may not be right for you, depending on your financial profile and potential impact on financial aid.

 

This can be particularly confusing in the case of 529 plans. These accounts have a legal owner, often the parents, with a designated beneficiary, the student. Instead, parents often think the owner of the account is the student since it is “for the student.”

 

What kind of flexibility or restrictions do you want to have on the money? 

 

Different account types have different restrictions. Whether you want to save for college, help with a car purchase, or help with a down payment if your student doesn’t go to college will influence how you save. I’ll review the possibilities and the financial aid impact of each option. Please speak to your own financial advisor or tax person to figure out which one is best for you.

 

Here are the basic options if you want to save something for college. Let's start with these. Each type would potentially impact the financial aid for asset and income purposes, as reported on the FAFSA

 


A bank account (checking/savings/money market/Certificate of Deposit)

Under your mattress, or in a cookie jar

Non-qualified (i.e. non-retirement account) accounts

These are the easiest types of accounts to open. Bank accounts should be self-explanatory, but the non-qualified accounts refer to any investment account that you may open at a brokerage or investment firm. You may purchase individual stocks, mutual funds, or other types of investments - and may even intend for this to be additional retirement savings. But they key is that the money is not in a retirement account, such as an IRA or 401k.

 

Financial aid impact - assets/reportable on FAFSA:

Counts for financial aid

 

Financial aid impact - income/reportable on FAFSA:

Interest, dividends, and capital gains generated each year would be taxable on your tax return, and therefore counts as income for financial aid purposes.

 

Restrictions on use/purpose:

None

 


529 Plans

There are actually two types of 529 plans with one being way more popular than the other. The most popular type is the savings plan. Different investment firms advertise where you put your money in and it's typically invested in some sort of mutual fund.

 

There is a separate type of plan called a 529 prepaid tuition plan. You are essentially pre-paying a percentage of the current tuition at a participating school in your state. In the future when your child goes to college, this account will be worth the same percentage of tuition as it was the day you opened the account. For example, tuition at a participating college is $10k and you put in $5k today. By the time your kid goes to school, if the tuition is $40k, your account would be worth $20k. You prepaid for $5k, or 50% of that $10k tuition. These plans aren’t nearly as popular as the 529 savings plans but they do exist in a dozen states though some do restrict new participants.

 

Financial aid impact - assets/reportable on FAFSA:

Counts for financial aid (even those accounts intended for younger siblings)

 

Financial aid impact - income/reportable on FAFSA:

Withdrawals for qualified expenses do NOT count as income for financial aid purposes.

 

Note: With the passage of the stimulus package in Dec 2020, distributions (for the student) from grandparent owned 529 plans no longer counts as untaxed income. This change takes place in the 23/24 academic year, but the FAFSA for that year would count 2021 income - so this change starts now. 

 

Withdrawals for non-qualified expenses would count as income since the earnings portion would be subject to income taxes, and therefore reportable on the tax return.

 

Restrictions on use/purpose:

Generally none for qualified higher education expenses, K-12 expenses, or repayment of student loans ($10k lifetime amount). Withdrawals are also allowed for other college related items, such as scholarships.

 

Withdrawals for any other purpose (i.e. non-education related) would be subject to income taxes on the earnings plus a 10% penalty.

 


Traditional retirement accounts (401k/403b/IRA)

Most financial advice would steer you away from using retirement accounts for college expenses as that money is intended for retirement. However, you are able to use money in these accounts should you choose to. Traditional retirement accounts refer to accounts where you contributed money on a pre-tax basis, meaning you didn’t have to pay taxes on the income earned. In exchange, the money is taxable when you withdraw.

 

Financial aid impact - assets/reportable on FAFSA:

Does not count for financial aid

 

Financial aid impact - income/reportable on FAFSA:

Annual contributions to a traditional retirement account does count as income even though the money was deducted pre-tax from your paycheck.

 

Withdrawals for any purpose do count as and reportable on the FAFSA. 

 

Restrictions on use/purpose:

None. However, withdrawals for qualified higher education expenses are not subject to the 10% early withdrawal penalty.

 

Withdrawals for other purposes would be subject to the 10% penalty, unless a qualifying exception applies.

 


Roth retirement accounts (401k/403b/IRA)

Unlike traditional retirement accounts, you don’t get a tax deduction on the contributions. But unlike the traditional accounts, you can withdraw the money tax free in retirement.

 

Similar to traditional retirement accounts, the advice to save these accounts for retirement applies, though Roth IRAs have a unique feature that makes it a bit more attractive IF you wanted to use the money for college.

 

Financial aid impact - assets/reportable on FAFSA:

Does not count for financial aid

 

Financial aid impact - income/reportable on FAFSA:

No impact for contributions like traditional retirement accounts since the money is after tax and would be included in income anyway.

 

For Roth IRAs, withdrawals of contributions are tax free and penalty free, but would count as untaxed income on the FAFSA and thus impact financial aid eligibility.

 

Withdrawals of earnings from a Roth 401k/403 or Roth IRA would be penalty free if used for qualified expenses.

 

Restrictions on use/purpose:

None. However, withdrawal of earnings for qualified higher education expenses are not subject to the 10% early withdrawal penalty.

 

Withdrawals of earnings for other purposes would be subject to the 10% penalty, unless a qualifying exception applies.

 


Investment real estate

Though not the most common way to save for college, there are those who want to use real estate as a way to pay for college. In fact, a family I know invested in three properties using the rental income as a way to pay for their three kids’ college expenses.

 

Financial aid impact - assets/reportable on FAFSA:

Counts for financial aid

 

Financial aid impact - income/reportable on FAFSA:

Interest, dividends, and capital gains generated each year would be taxable on your tax return, and therefore counts as income for financial aid purposes.

 

Restrictions on use/purpose:

None

 


Permanent insurance/annuities

Some options that make people cringe can be a very effective way to save for college, if done correctly. In many ways, the cash value of permanent life insurance, for the tax standpoint, is very similar to a Roth IRA. There’s too many details to review here, but done correctly, life insurance can be among the best ways to save and pay for college.

 

Financial aid impact - assets/reportable on FAFSA:

Does not count for financial aid

Annuities do count on the CSS Profile form

 

Financial aid impact - income/reportable on FAFSA:

Income earned inside a life insurance policy or annuity does not count for financial aid purposes.

 

Accessing the cash value as a loan against the cash value would not count as income, nor have a tax impact.

 

Withdrawals from annuities would generally count as income and may be subject to the 10% early withdrawal penalty.

 

Restrictions on use/purpose:

None



We've gone through a lot of choices. The “right” choice isn’t so simple. It depends on your situation, such as how many kids you have, how much you can contribute/save, and how many years before college. A thorough analysis of your situation is required first. If someone simply says, "...just do this" without your full information, they have no idea what they are talking about.

 

What also matters are those questions we covered at the beginning of this post. Answer those questions first before putting any money away for college in any type of account.



I write primarily on college financial aid and student loan topics. My firm has a particular specialty in working with self-employed or small business owners on these issues. 

 

My content is for educational purposes only and should not be construed as advice or any kind of solicitation to buy or sell anything. As always, consult your own financial or tax professional for your own specific situation. Your mileage may vary. Batteries not included. 

 

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