Thoughts on Saving for College
It sounded like a good idea...
by Steven Fraser, PhD
I know that each year sometime after the Super Bowl and before the Masters, I have to do my taxes. I love to do my taxes. Of course I write that with a modicum of sarcasm. But in a curious way, I do enjoy doing my taxes. As I tackle the task each year, I feel like I am staying up to date with changes in the tax code. I also feel a confusing sense of both accomplishment and relief. Completing my taxes also serves as sort of performance metric as well. I know I should not want a refund, but I also do not want to write Uncle Sam a check. If Line 75 of 1040 is a small positive number, I feel I planned well. I estimated taxes and withholdings well. In short, it was a good year. At 7258, we know taxes matter.
This year was different. Way different. Our daughter left the nest and in turn left us with college bills to pay. When you start paying for college, you really get to see how well that plan of saving for college turned out. I learned some things along the way.
Paying for college is very different than saving for college. Saving for college sounds like the right thing to do (it is!), is relatively easy to get started, and you feel good about it. We started saving for college using a 529 College Savings Plan. A 529 plan is an educational savings program offered by states or eligible educational institutions. In most cases, individual states operate the programs using well-known investment firms. For example, Vanguard manages an option for 529 plans in Colorado as well as other states. Investing in a 529 allows your investment to grow tax free as long as the funds are used to pay for qualified educational expenses. What’s more, if you have more saved than your beneficiary (student) requires, those funds can be can be rolled to a plan for the benefit of another member of the family of the beneficiary. The definition of family is rather broad; it includes cousins too! You do not have to be a resident of a particular state to utilize their 529 plan. Some states offer tax benefits at the state level (including Colorado), so it is important to select a plan that maximizes your savings. So we started a 529 plan and indeed felt good about it. It turns out saving for college was pretty easy; paying for college is complicated. I wish I had learned more about how to pay for college when we started saving for college. So as we approach the start of a new school year, what follows are a few of the lessons I learned.
The Government is here to help. No, they really are. There are no fewer than 12 tax benefits for education outlined in IRS Pub 970. Each of the tax benefits for education listed is unique, has different eligibility thresholds (usually specified by AGI), and interact. In this blog post, I will focus on the 529 plan; which ironically isn’t even called a 529 plan in Pub 970, it is called a Qualified Tuition Program (QTP). (As an aside, the “529” moniker comes from the section of the Internal Revenue Code that established the plans in 1996.) “Qualified” expenses are things like tuition, room and board. These expenses are qualified...until they’re not. Thankfully, for 529 plan savers, you can use those tax-free earnings to pay for your student’s living expenses. Or mostly. If your student lives on campus, this is clear-cut – those room and board expenses are unlimited and qualified educational expenses. If your student lives off campus, the level of your qualified expenses is limited to the allowance for room and board published as part of the school’s cost of attendance. The bottom-line? Beware of assuming that all your room and board expenses are qualified when your student looks for one of those new apartment complexes with all those great amenities. Did your college dorm/apartment have a lazy river pool? Mine didn’t.
Thankfully, there is a tax form from the university that helps you keep all these figures straight. I hope you read more sarcasm there. You will receive a 1098-T Tuition statement. The statement has a box for Payments received for qualified tuition and related expenses, and another for Amounts billed for qualified tuition and related expenses. Our 1098-T reported only payments received. You might think if you paid a certain amount to a school you would recognize the number reported in the Payments received box. You may be right. More likely though, you will not recognize the number reported. Recall the “qualified” discussion above. Expenses for items like insurance and transportation are not qualified expenses. However, these charges are often included on a per-credit hour basis. For example, if you paid $200 per credit hour in tuition, it is possible not all $200 will be considered a qualified expense and reported on your 1098-T. Make sure you read the accompanying letters that come with your 1098-T carefully.
You will also be introduced to the 1099-Q. This form will come from your 529 plan. Many 529 accounts are held by parents as owners, with the child (student) as beneficiary. These are the forms that report how much you withdrew, as well as the cost basis and any gain. (Remember these gains are why you saved for college in the first place--they are tax free if used for qualified expenses!). It would be great if you received just one. Again, unlikely. If you have 529 funds paid directly to the institution, the 1099-Q is issued in the name of the student. If you have 529 funds paid to you so you can write the checks (for room and board, text books etc.), the 1099-Q comes in your name, and you should keep any supporting documentation. No matter how many you receive, the figures on the 1099-Qs should match what you withdrew for the year. No forensic accounting needed here.
Be careful of the amount you withdraw from the 529 Plan each year. Take out too much, and you risk not only paying tax on the gains, but also a 10% penalty. Tax impacts are calculated on a calendar basis while schools operate on an academic calendar (think August through May). For tax purposes, 529 plan withdrawals must occur in the same calendar year the expenses are paid. And yes, it gets worse. I have not even addressed cases where your student may have earned a scholarship, or obtained a student loan. Scholarships for tuition essentially reduce the amount of qualified expenses, but the owner could withdraw the amount of the scholarship from the 529 plan without penalty (but would pay taxes on any capital gains). In my case, my daughter will likely attend medical school so we decided to leave the “scholarship money” in the 529 to preserve the tax advantages.
Despite the intricacies of 529 plan administration, there are potential estate planning benefits for those thinking about funding one. While there are no income restrictions to make contributions to 529 plans, and contributions are only limited to the amount necessary to provide for qualified expenses, there could be gift tax implications. Fortunately, the IRS allows married couples to front-load five years worth of gifts (currently $28,000 x 5 = $140,000) for contributions to a 529 plan. Two important caveats here: 1.) The owner has to survive the following five-years or some of the contribution may flow back into their estate (grandparents beware); and 2.) There are no other annual gifts from the owner to the beneficiary in that subsequent five-year period.
All of this discussion may sound like you need a specialized college degree just to navigate the world of financing and paying for higher education. You don’t. Is it complicated? Yes. What is important is to be aware of how we might spend the critical dollars we save for college as we plan and save--before it is time to pay for college. At 7258, we know taxes matter.
College Savings Plan Nuggets:
- POWERFUL TOOL: 529 plans are likely to be the best way to save for college.
- LOCATION MATTERS: Off-campus room and board expenses may not all be qualified 529 expenses.
- BE CAREFUL WITH SO-CALLED “TUITION”: It might not all be qualified.
- TIMING MATTERS: Payments for qualified expenses and withdrawals from 529 plans must occur in the same calendar year.
- STAY VIGILANT: Meticulously track your expenses and withdrawals.
- MORE THAN COLLEGE: 529 Plans can be used as an estate planning tool.
- TAXES MATTER: Use the tax code to your advantage.