When the Bills Come Due
Tread mighty carefully when tapping your college savings accounts
It's a message that has been drummed into parents' heads for years: Take full advantage of any and every type of investment account you can--especially tax-advantaged ones--to save for your children's enormous college bills.
Clearly, the message has sunk in. A majority of families are now saving for college using at least two different types of investment vehicles. And 1 in 8 households is using three or more different types of plans.
Often, this mix includes old-fashioned custodial accounts, such as Uniform Gifts to Minors Act (UGMA) accounts, alongside tax-deferred education programs like 529 savings plans or Coverdell Education Savings Accounts (ESA s). Still other households are investing in a combination of tax-advantaged plans and taxable brokerage accounts.
But here's the scary part: After spending several years trying to decode the alphabet soup of UGMA s, ESA s, IRA s, and 529s to figure out which plans to invest in, parents face the equally confusing task of determining how to withdraw money from those accounts once the children start college. "This is when things start to get really complicated," says Raymond Loewe, founder and president of College Money, a New Jersey-based college financial planning practice. Even for those who have been saving in just a few different accounts, determining how to draw down those savings isn't always cut and dried. The decision could determine how much financial aid a child is eligible for, as well as affect how much a parent pays in taxes.
Aid considerations are a big reason many planners recommend that parents who have traditional custodial accounts like UGMA s deplete those first to pay for the initial batch of college bills. That's because money saved in a custodial account is held in the child's name to take advantage of the kid's lower tax bracket. And anything in a child's name is worse from an aid standpoint than assets held in a parent's name (colleges will assume that 35 percent of the student's assets can be used to pay for school, versus up to 5.6 percent of the parental assets).
Since "UGMA money hurts your financial aid eligibility, it makes sense to get rid of it first," says College Money's Loewe. That way, once you exhaust those assets early on, you may be eligible for aid by the time your child reaches his or her junior and senior years.
But even if you are not banking on aid, there's a good reason to tap the UGMA first, experts say. Money in those accounts is legally the property of your children. And once they hit the age of majority (typically 18 or 21), they can do with it whatever they wish--including backpacking across Europe rather than paying for a semester's worth of room and board. "Before they wise up to this fact and buy that Corvette, it may be wise to use the UGMA for college expenses," says Gail Fialkow, a financial planner with Capital Planning & Investments in Fairfax, Va.
Prepaid pitfalls. Financial aid is also the reason planners say parents who have purchased credits through prepaid tuition programs--many of which allow families to lock in tomorrow's tuition at today's prices--should use them up before tapping 529 savings plans or Coverdell ESA s. Prepaid tuition credits are extremely detrimental when it comes to financial aid, reducing a student's aid eligibility dollar for dollar. Also, most state-run prepaid tuition plans--along with the so-called Independent 529 plan, which is sponsored by a nonprofit organization representing hundreds of private universities--allow families to prepay only tuition and mandatory fees. So, if you have a combination of UGMA s and prepaid tuition credits, consider using the prepaid assets for actual tuition costs and student fees while using the UGMA for room, board, and textbooks.
After you've spent down the assets that are considered detrimental to financial aid eligibility, the next type of account to consider tapping is a Coverdell ESA.
Coverdells have a lot in common with 529 savings plans, an increasingly popular college savings vehicle that is considered by many to be the 401(k) for college savings. For example, Coverdell accounts and 529 plans--which are sponsored by virtually all 50 states--let parents invest money through mutual funds or similar investment options in a tax-deferred setting. In both Coverdells and 529s, money withdrawn for qualified educational expenses, including tuition, mandatory student fees, room and board, and other required expenses, can be taken out tax free, a feature that makes both accounts quite attractive to tax-conscious investors.
In both types of accounts, the assets are considered to be the property of the parent (or whoever opened the account) and not the student beneficiary. This wasn't always the case. Coverdells used to be considered an asset of the student beneficiary, but that was changed in 2004 by a ruling from the Department of Education. So today, both Coverdells and 529 savings plans prove beneficial from a financial aid standpoint.
But there's one big difference. Under the rules of the Coverdell, balances saved up in these plans must be used no later than 30 days after the beneficiary turns 30. "If you don't use it up by 30, the earnings will come out taxable," says Susan Hirshman, a wealth strategist with JPMorgan Funds. Moreover, that money may be subject to an additional 10 percent penalty tax. The IRS will allow you to roll any Coverdell balances into an account of a family member of the beneficiary, such as a sibling. But again, that beneficiary must be under 30.
Because 529 savings plans are the most flexible--there is no age at which the money must be used, the assets can be transferred to a relative of the original beneficiary, and there are often state tax breaks--it makes sense to keep those assets invested and sheltered from taxes the longest. If need be, money that's not used up can be rolled back into the parent's name or into the name of a grandchild to be used for educational expenses.
For those with multiple 529 accounts, it makes sense to consider their overall performance and cost, says John Heywood, a principal in charge of the mutual fund giant Vanguard's education markets group. If one of the plans has solid investment options and low fees while another is only so-so and carries high expenses, then consider liquidating the high-fee plan first. This will allow you to shelter your most beneficial plan the longest. Also, if you are using one 529 to invest mostly in stocks and another to invest mainly in fixed-income investments, an easy option is to tap the higher-risk, equity-laden portfolio first.
Here's one more bit of advice: If you're withdrawing assets from a 529 to pay for qualified educational expenses, make sure you withdraw the money in the same calendar year as the bill to keep the IRS happy, says Joseph Hurley, CEO of the website savingforcollege.com.
Among all types of college savings vehicles, a parent's IRA should typically be used as a last resort. Financial planners note that while students have access to any number of loans and scholarships for college, parents have no similar options to fund their own retirement. So if you have the financial wherewithal to avoid tapping your IRA for college, leave it alone.
Keep looking. Another case against using withdrawals from an IRA to pay for school--in addition to the fact that you may have to pay taxes on the withdrawal--is that money pulled from an IRA will be considered income for the purposes of financial aid, notes Hurley. On the other hand, qualified withdrawals from a parent-owned 529 or a Coverdell do not count as income.
Finally, even if you have more than enough money saved in a combination of 529s and other accounts, don't forget to consider using low-interest loans to improve your cash-flow situation, says Karen McIntyre, a financial planner with Executive Financial Services of Spring House, Pa. "You have to think about maximizing your resources, and low-cost borrowing can be a resource for parents," she says.
That's what Dan and Jacqui Sattler are doing. The couple, who fittingly live in a town called Collegeville, Pa., have tried to keep things relatively simple when it comes to saving for college for their oldest daughter, Emily. The Sattlers started by opening an UGMA account in Emily's name when she was born. But then, a few years back, they heard about the tax advantages of investing through Pennsylvania's guaranteed tuition savings plan, which lets parents lock in a rate of return equal to tuition inflation. So they rolled Emily's UGMA into that.
Today, they've got more than enough to fund four years of undergraduate education for Emily, who is heading off to Shippensburg University in Pennsylvania. And Emily recently won a Pennsylvania Board of Governors scholarship, which essentially pays for tuition, leaving her parents to pick up the tab for room and board and miscellaneous expenses.
Yet to cover costs during Emily's first semester, the Sattlers relied on a combination of loans (including a no-interest loan offered by their daughter's school district and a low-interest Stafford student loan in Emily's name) and their own savings--rather than tapping their daughter's tuition account.
Among the reasons: Emily has two younger siblings. And Dan and Jacqui are hoping to preserve as much of Emily's tuition-savings plan as possible, since any leftover balance can be rolled over to either Melissa, 14, or Benjamin, 11.
"Hopefully," says Sattler, who works as an information technology manager, "we won't have to tap that account that much, and some of it can flow into Benjamin and Melissa." Now that's planning ahead.
Taking The Money Out
Withdrawing cash to pay for college can be as challenging as saving it. Be mindful of the effects on both financial-aid eligibility and taxes.
PLAN TYPE
529 savings plan: A tax-deferred investment account.
PROS
Money is not in student's name, helpful with financial aid.
CONS
High fees on some plans. May limit your investment options.
PLAN TYPE
Coverdell Education Savings Account: Also tax deferred.
PROS
Money is not in the student's name.
CONS
Use money before student is 30, or earnings are taxable.
PLAN TYPE
Uniform Gifts to Minors Act: Account in child's name.
PROS
Taxes on income are paid at student's lower rate.
CONS
Reduces aid eligibility. Belongs to student at adulthood.
PLAN TYPE
Prepaid tuition plan: Pay now for future tuition and fees.
PROS
Parents can lock in tomorrow's tuition at today's prices.
CONS
Tuition credits reduce student's financial aid eligibility.
PLAN TYPE
IRA: Tax-deferred parental retirement account.
PROS
A possible source of funds, to be used only as a last resort.
CONS
May leave parents lacking money for retirement.
This story appears in the September 5, 2005 print edition of U.S. News & World Report.