College Savings Strategies
It’s that time of year again, where millions of eager students will be leaving home to start their first year of college and, for a traditional student, this means 4 years of tuition, housing, books, and a host of other related fees. As a parent, you want to do everything you can to see your child attend the best academic institution, but this can come with a hefty price tag. Most physicians and, therefore, their children will have assets and earnings resulting in a high Expected Family Contribution (EFC) greatly limiting or excluding their future college student from receiving financial aid. Financial planning for college can help your student focus more on their studies and less on how they will pay for their priceless education without being burdened by debt after graduation.
The graduating class of 2016 walked across the stage, threw their hats in the air and began their post-collegiate life with an average debt of $37,712 per student, reflecting an increase in average student loan debt of 6% compared to 2015. A traditional in-state freshman beginning their studies this fall can expect tuition, fees, and housing to cost an average of $21,000 per year; out-of-state and private university attendees can plan to spend an annual average of $35,370 and $45,370 respectively.
With costs of a traditional 4-year degree continuing to increase, developing an overall savings strategy is critical to helping your student avoid the stress of mounting student loan debt. As part of this strategy, you should be utilizing Roth IRAs and 529 plans to help you and your student minimize borrowings and stretch your dollars further.
Roth IRAs are a great way to save for college and retirement. Contributions to a Roth IRA are not tax deductible but the earnings inside a Roth grow tax-free. Funds can be withdrawn penalty free from a Roth IRA for college expenses (including books and room and board) for you, your spouse, your children and your grandchildren. When used for qualified education expenses, the entire amount of your initial contributions can be pulled out penalty and tax-free, only any earnings would be taxable. Fortunately, distributions from a Roth IRA are always treated as a return of your contribution first. If your child’s education expenses are less than your Roth IRA balance, you may not need to use the earnings to cover college expenditures and therefore avoid any tax.
A major benefit of Roth IRAs is that you are saving for both retirement and college. In the event your child receives scholarships or all the Roth IRA funds are not needed to cover tuition and fees, you have additional retirement monies you can pull out at 59 ½ tax and penalty free. Unlike a 529 plan, the funds do not have to be used exclusively for higher education; therefore, you avoid the 10% penalty on any excess funds not needed to cover education expenses while also adding to your retirement reserves.
Most physicians will find their income puts them over the limit for making Roth IRA contributions directly. When a married taxpayer’s income exceeds $196,000 ($133,000 for single taxpayers), contributions cannot be made to a Roth IRA so a “backdoor” IRA contribution must be made. Taxpayers can make a nondeductible traditional IRA contribution then roll these funds into a Roth IRA. Using this approach allows taxpayers at any income level to make contributions to a Roth IRA.
One con of Roth IRAs is their low annual contribution limit. Married taxpayers under age 50 can’t exceed annual contributions of $11,000 while married taxpayers over 50 can contribute an additional $2,000 for a total annual contribution of $13,000. One way to increase Roth IRA contributions is to employ your children (maybe only a few weeks in the summer). This gives your child some earned income which is required to make a retirement contribution and a Roth IRA can be set up in their name. Any remaining funds after college could be used to help purchase their first home or simply as the start of their retirement savings. Assuming no other income, children can receive wages up to the single standard deduction amount ($6,350) tax-free, giving them enough earned income to make the maximum Roth IRA contribution.
If you are looking for immediate tax savings, then a 529 plan can provide you with a reduction in your state taxable income. Contributions made to a state plan in a state offering a tax deduction for which you have a tax liability will reduce your tax bill in the year of contribution, earnings will grow tax-free, and withdrawals for education expenses are tax-free, including earnings. For South Carolina taxpayers contributing to a South Carolina 529 plan, this means you are saving approximately 7% in state income tax. A contribution of $10,000 will have a net cost to you of $9,300. If you are able to contribute more than a Roth IRA will allow and you want to stock away more cash for college, it’s a great idea to use both a 529 plan and a Roth IRA. After maximizing your Roth IRA, married taxpayers can still make a $28,000 contribution annually to a 529 plan, per child (14,000 for single taxpayers). Contributions above this amount exceed the annual excludable gift and would need to be reported on a gift tax return.
Remember, try not to over-fund your 529 plan; if the cost of your child’s education is less than the amount saved, your withdrawal will be taxed and charged a 10% penalty. Income taxes and penalties can be avoided by changing the beneficiary of the 529 plan to another family member (other children and their descendants, stepchildren, siblings, parents, stepparents, nieces, nephews, aunts, uncles, in-laws, and first cousins) however, if the new beneficiary is in a different generation than the original, there will likely be gift-tax consequences.
For those who may be strategizing closer to the start date of their child’s college enrollment, an election can be made to make a one-time 529 plan contribution of $140,000 for married and $70,000 for single taxpayers. This election allows you to make five years of excludable gifts in a single year without any gift tax consequences. If the full $140,000 is contributed, you will not be able to make additional contributions to the plan until five years after this lump sum gift. If a lesser amount is contributed, it’s deemed to be contributed ratably over five years and additional contributions for the difference between the annual excludable gift amount could be made in the subsequent 5 year period.
For those who haven’t saved, yet, but your child is already a student, you can put the exact cost of tuition into the 529 plan each year and take it right back out to pay for qualified education expenditures. There is no time requirement for keeping the money in the account and you will reduce your state taxable income by the amount of your contribution.
These are just a few of the options to consider as part of an overall college savings strategy. WebsterRogers can create a financial plan that works best for you, your family and includes estate and gift tax considerations. Please contact us for more information on how we can help ease the financial burden of a first-class education for your children.
Melissa Barbour, CPA joined WebsterRogers in 2012 and currently works as a Tax Senior Manager in our Charleston office. She is a gradaute of James Madison University with a Bachelor of Science in Accounting and holds a Master's of Accountancy from the College of Charleston. Melissa is a member of the South Carolina Association of Certified Public Accountants (SCACPA) and the American Institute of Certified Public Accountants (AICPA). You can reach Melissa at firstname.lastname@example.org or (843) 577-5843.