As a new parent, you have a lot on your plate. You have an entirely new set of demands on your time and energy, and you are trying to navigate the many unknowns of parenting. Preparing for something 18 years into the future is unlikely to be your top priority. However, with college education costs having skyrocketed over the past few decades and the application process becoming ever more competitive, it is never too early to begin thinking about your child’s college education.
To help prepare you for one of the most significant financial and educational undertakings that you will ever encounter, Pekin Hardy Strauss has partnered with Valle Educational Consultants to develop a roadmap called The College Planning Lifecycle. In this three-part article series, we will help you understand this lifecycle and provide you with strategies for managing the challenges it poses for families. We will examine three stages in our series as follows:
- Stage 1: The Early Years
- Stage 2: The High School Years
- Stage 3: Grandparents Can Help, Too
Stage 1: The Early Years
In part one of this guide, we will provide important information for families with young children. At this early stage, you may be wondering what, if anything, you can do to prepare for something that may be many years away. This guide provides our suggestions for ways to begin to prepare yourself financially and your children educationally and emotionally for this important undertaking.
Preparing Yourself: Creating a College Savings Plan
As a new parent who is already thinking about college, you have given yourself one significant advantage: time. One of the most important actions you can take for yourself at this stage is to begin to save for your child’s education, giving yourself a longer time period over which to put money aside.
As with any financial planning topic, there is no one-size-fits-all approach when it comes to saving for college, so we encourage you to contact us to discuss your unique situation and to develop an individualized plan for meeting this financial goal. However, we hope this guide will help you better understand the college saving process and provide you with a framework for beginning to think about this important topic.
Especially if your children are very young, there may be many unknowns around their education, but one thing is certain: college is expensive and getting more so every year. As the chart below illustrates, average tuition costs among national universities have soared over the past 20 years. Tuition at private universities has increased at an average rate of 4.8%, while out-of-state and in-state public university tuition has increased at an average rate of 5.3% and 6.0%, respectively. These increases in education costs have outpaced the increase in the broader cost of living (as measured by the Consumer Price Index) by 2.6%, 3.1%, and 3.8% per year, respectively, over this time frame. While there is no guarantee that education costs will continue to increase at these rates going forward, the numbers certainly argue for planning and preparation by parents who wish to assist their children with college education costs.
How to Save: 529 Plans vs. Custodial Accounts
One important consideration for parents at the beginning of this process is simply where to put their college savings. To facilitate families’ college savings efforts, several savings vehicles have been created that enjoy various tax advantages and levels of investment flexibility, but also come with their own rules and regulations. 529 plans and custodial accounts are two of the most common ways to save for college, but they have distinctly different benefits for families. Understanding the differences between the two savings methods is essential to choosing the right one for you and your children.
There are two basic types of 529 plans: general savings plans and prepaid tuition plans. A savings plan simply allows the parent to put aside money for any college expenses, whereas a prepaid tuition plan allows a parent to pay for future tuition at today’s rates.1 Every state has its own plan and may offer either one or both types. Parents aren’t limited to 529 savings plans with their state of residence (though there are often financial incentives to do so).
A custodial account is a taxable investment account that is opened on behalf of a child. There are two types: Uniform Transfers to Minors Act (UTMA) accounts and Uniform Gift to Minors Act (UGMA) accounts. UGMA accounts are limited to assets like cash, securities, and annuities, whereas UTMA accounts can hold almost any kind of asset. In both cases, a custodian sets up the account for a minor and controls the account until the minor reaches legal adulthood.
How Much Can I Save Each Year?
On an annual basis, there is technically no limit to the amount a parent can contribute to a child’s custodial account or 529 plan, but gifts above a certain threshold ($15,000 per parent in 2020) may have lifetime gift tax consequences. In a 529 plan, a parent can also make a lump-sum gift to cover five years of plan contributions with no gift tax consequences; in 2020, one parent could contribute $75,000 or a married couple could contribute $150,000 with the five-year election option. Parents using custodial accounts have no such lump-sum contribution option. Neither 529 plans nor custodial accounts have contribution limits based on income, so even high-earning parents are able to save into these vehicles.2
College Planning and Taxes
A 529 plan is a tax-beneficial way to save for college, at least at the point at which you withdraw funds to pay for educational expenses. Contributing to a 529 plan does not provide any Federal tax benefit, but it may provide relief on state taxes.
Withdrawals from a 529 plan, however, receive very favorable tax treatment. The investments in a plan grow tax-free, and as long as the funds are used for educational purposes, no taxes are owed upon withdrawal of the funds.3 In this respect, a 529 is somewhat akin to a Roth IRA, with the tax-free distributions used for college education rather than retirement.
There are no special tax benefits to using funds for education with a custodial account. Gains in the account are typically taxed at “kiddie tax” rates rather than the custodian’s income tax rate. Before the child turns 18, interest and dividends may be taxed if they total more than $2,100.
Weighing the Pros and Cons
Parents choosing between 529 plans, custodial accounts, or simply paying tuition directly have to consider the pros and cons of each plan, their own financial situation, and their child when deciding which to use. A 529 plan can offer the parents considerable tax benefits, but only if the money is used for educational expenses. Custodial accounts do not have the same usage restrictions, making them far more flexible, but they also lack the significant tax benefits of a 529 plan.
Paying tuition without the use of one of these savings vehicles also has advantages, as a payment made directly to the school does not count towards the annual or lifetime gift tax exclusion. For parents with significant assets, this can be a good way to pass wealth to their children.
Another important consideration for some families is how their college savings will affect a child’s financial aid eligibility. Because a custodial account transfers assets to the child’s estate, these accounts often have a greater effect on financial aid eligibility than a 529 plan, which leaves the money in the parents’ estate.
Parents who are trying to determine which account is most appropriate for their family should consider all of the differences above and perhaps consult with a trusted financial advisor for help making the choice.
How Much Should I Save?
Determining how much to set aside for a child’s education costs can be tricky, because it is impossible to know exactly how college costs will evolve over time, and the assumptions involved are highly dependent on the educational aspirations of the child. There are numerous online college savings calculators that are available. We have found the calculator provided by The College Board to be useful in providing an estimate of potential college costs and the level of saving that would be necessary to fund those costs.4
We understand the magnitude of the challenge that parents face with respect to saving for their children’s college educations. With limited resources, important savings decisions must be made, and we would urge parents to always prioritize retirement savings above education savings. Financing for education is readily available, while the same cannot be said for retirement: you cannot borrow to pay for your retirement. However, in general, we encourage parents who wish to help fund their children’s college educations to start thinking seriously about this goal as early as possible and to begin committing capital as soon as they are willing and able. There are additional timelines that come into play if a student wishes to apply for college financial aid and/or scholarship dollars. In this case, we would urge a family to begin exploring options no later than the student’s freshman year in high school to best prepare for lower college costs. And, of course, we are here to help our clients understand the challenges posed by education costs and to develop a thoughtful plan for meeting those challenges.
Preparing Your Children:
Laying a Solid Foundation & Building on It
Our role as parents is to prepare our children to be independent people with the ability to navigate life’s challenges and hopefully thrive. Although the college admissions process typically starts in the later years of high school, an effective foundation should be built starting in the early years — fostering a child’s interests and natural skills and then providing opportunities to explore those interests and hone skills.
The early childhood years (Pre-Kindergarden-5th grade) are all about building muscle — setting realistic expectations, encouraging autonomy where appropriate, and allowing mistakes and the consequences to unfold in order to teach important lessons. The early years are the time to model behaviors you ultimately expect of your child. When it comes to life’s big discussions, your child will struggle less with expectations as the pattern was set in motion since childhood. With an awareness toward age-appropriate interactions, encourage your child to engage 1:1 with older children and adults. Rehearse critical interpersonal skills like shaking hands, good eye contact, and active listening skills. It’s important for children to practice verbalizing their feelings and talking through dilemmas, solutions to resolve them, and noting lessons learned. Troubleshooting and redirecting for future efforts are critical to building self-confidence and skills related to individual or collaborative work in school, college, and career.
Intellectual curiosity should be stimulated early and often. No matter what the interest area, encourage children to read. Does your child have an aptitude for math? Love to write, draw, and/or build? Do they like ballet or play violin? Soccer, volleyball or chess? Are they curious about nature or how a computer works? Dial-in on what makes your child unique.
As our world is growing ever more interconnected, a long-standing trend for higher education has been to seek out candidates that have a passion for helping others and/or improving their surroundings. A concerted effort engaging in community service may matter on a college resume and ultimately makes the world a better place. Feeling compassion for another’s plight may not always come naturally and can be fueled by an advocacy mindset that needs to be nurtured. You might cultivate compassion through family chore assignments at home. Or, get involved with your child in an issue close to the family’s heart in a neighborhood or community. Planting seeds to inspire your child will yield a natural tendency for them to seek out opportunities to help others, preferably balanced with a dose of humility and a desire to have a positive impact.
In middle school, it’s all about continuing to build upon an established foundation. For a young student to miraculously have an appreciation for college costs as the time approaches is not realistic. Discuss whether the student ultimately will be contributing money in the form of earnings or scholarship to offset college costs – well before high school. Understanding the value of money is important for a child and can have far reaching benefits no matter the college or career path.
As a parent of a young child, it can be tempting to focus only on the day-to-day responsibilities associated with raising your child (and there are many!) and letting the future worry about itself. However, as we have shown, you have an opportunity to significantly improve your child’s long-term educational prospects by starting to prepare yourself and your child in these early years. In Part 2 of this series, we will discuss how you can build on this foundation as your child enters and progresses through high school.
[1] Some states offer pre-paid tuition plans for in-state public institutions that allow families to lock in a guaranteed tuition cost, regardless of how much costs might increase prior to a child’s matriculation. Funds invested in pre-paid tuition plans can be used at private and out-of-state institutions, though only on a dollar-for-dollar basis.
[2] How much can you contribute to a 529 plan in 2020?, Saving for College
[3] 529 Plan assets used for purposes other than qualified education expenses are subject to a 10% penalty, as well as applicable Federal and state income taxes. Visit the IRS website for a description of qualified education expenses.
[4] College Savings Calculator, College Board
This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) and Valle Educational Consultants (VEC), for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future, there are no assurances that any predicted results will actually occur.
Valle Educational Consultants (VEC) is a Chicago-based college admissions advisory practice. Specialists in the college admissions process, they guide and empower families and their students based on each unique situation. VEC is dedicated to providing information in a supportive way, customized to each student’s needs as they navigate the admissions process.
