Saving for College - Pros & Cons of Many Options

There's a lot to plan for in life. Plan for capitalizing on opportunities in good times, and plan to reduce financial pressures in not so good times. Plan for taking care of parents. Plan for your retirement. Plan to buy a house. Plan for investing. 

Benjamin Franklin once said, "by failing to prepare, you are preparing to fail." That might hit each of us a little hard in the nose sometimes, however it seems to consistently ring true. For all things in life, if we have a plan, we have a greater chance at success. That doesn't mean we may never deviate from the plan, because a good plan also remains flexible. Regardless, the first step is to outline a plan.

So how do we plan for college for our kids? The good news is we have plenty of options.

Once you have determined how much you are able to save each month, then you have an idea of how much you can contribute to your child's college account.

But which account is best for you? Let's go through some pro's and con's for different ways to plan for college.

1) The 529 Plan - This might be one of the most commonly mentioned strategies for college, however it may also be one of the most restrictive. 

The Pros

1. You may get a small tax break from your contributions each year, depending on if your state has income tax. For instance, in Georgia the state income tax is 6%, so if you and a spouse contribute $4,000 each for a total of $8,000 (this is the Georgia 529 income tax deduction threshold), it may save you about $480 in state income tax. 
2. The money can be used for qualifying educational expenses without tax or penalty, which means the money grows "tax-free" in this account over time. This is by far the biggest pro and why many people initially think of a 529 plan. A relatively recent change now also allows money to be used for K-12 educational expenses too. 
3. You can change the beneficiary on 529 plans. So if the oldest child gets scholarships and doesn't use all of the money in the 529 plan, it can be changed to benefit a younger child for his or her college or education expenses.
4. The owner of the 529 account has control over the account. Even when a child turns 18 or 21, you as the parent or grandparent still have full control over how the money is used.

The Cons

1. Contribution limitations of $17,000 per year (this is the annual gift tax exclusion) or $85,000 in a single year counting as the contributions over 5 years. If you make the $85,000 one year contribution, you must report the 5 year election on the IRS form 709. 
2. From #1 on the Pro's, the tax benefit is often not as large as some people first think. 
3. If there is money left in the 529 plan after the youngest finishes their education, and it is withdrawn from the 529 account, you will pay ordinary income taxes plus a 10% penalty on the account balance being liquidated.
4. You are often limited on how the 529 dollars can be invested. Very similar to an employer-sponsored retirement plan, you may only have a few funds offered to invest in.

2) UGMA/UTMA 

The Pros

1. Unlike the 529 plan, if money is not used for college or educational expenses, there is no 10% penalty.
2. If there is any income earned on the money in the account, it is taxed at the child's rate who is receiving the gift/funds, but possibly also at the parent's rate too. Just like the 529 plan, the $17,000 per year gift tax exemption is the same.
   1. The first $1,050 of unearned income (investment income) may be tax-free.
   2. The next $1,050 of unearned income is then taxed at the child's tax rate, or 10% if you include the child's income on your return.
   3. Any amount above $2,100 then goes to the parent's tax return.

The Cons

1. Once the child turns 18 or 21 (depending on account structure), the child gains full control over the account and can use them for any purpose.
2. Because the account is tied to the child's "finances", it could impact the ability to qualify for needs-based scholarships and grants.
3. Unlike the 529 plan, the beneficiary to an UGMA/UTMA account cannot be changed.
4. Contributions to the account are not tax-deductible and earnings are subject to federal, and possible state and local taxes.

3) Investment Account in Parent's Name

The Pros

1. This money can be used for any reason, with no penalty in accessing the money (just capital gains taxes on any stock/fund sales).
2. You have thousands of investment options, as compared to maybe a dozen or two options within a state-sponsored 529 plan.
3. Since the money is in the parent's name, there is no ability for a child to gain access and potentially make an emotional decision at too young of an age.
4. This account can be integrated across the parents' overall finances for strategies like tax-loss harvesting or opportunity zone funds depending on the year-to-year gains or losses in the account.
5. There are no contribution limits.

The Cons

1. There is no deduction against the parent's income for taxes.
2. This counts as an asset on the parent's balance sheet if applying for financial aid.
3. The capital gain tax rate is based on the parents' income.

4) Cash Flow

The Pros

1. Often the most efficient way to pay for college given the fact that you can let existing (often larger) assets continue to grow and take advantage of the power of compounding versus having to liquidate those accounts and reduce their potential for compund growth.
2. By making a direct payment to an accredited institution, you avoid having that payment count as a gift on your taxes. The gift tax limit for 2023 is $17,000, where many college tuition costs can be well in excess of that per year.

The Cons

1. You may not have any tax benefits to doing this.
2. It reduces your ability to save money for 4-5 years (or more) which may be at a crucial point in your retirement journey where that additional savings is important.

5) Real Estate

The Pros

1. It's an asset in the parents' name.
2. It generates income for the parent's before a child goes to college, and can help pay for college tuition while in school.
3. There may be some tax benefits to owning real estate, like depreciation, mortgage interest and property tax deductions, etc.
4. The property could be sold after a child graduates to pay off any student loan debts that were incurred during school.

The Cons

1. You have to find tenants for potentially multiple years before your child goes to college.
2. College kids don't always treat things with the same respect as you do (i.e. lot's of potential repairs).
3. Investing in real estate, like anything, involves risk and ongoing management.
4. Your child may decide to go to a different college than the city you purchased the real estate.

6) Life Insurance

The Pros

1. Policies can be funded like an investment or savings account - meaning each year the contribution can vary.
2. Growth within the policy is not dependent on the stock market, and reduces the potential for downside risk as a child reaches college age.
3. By the time children go to college, the cost to borrow against the policy may be less than the growth of the policy (meaning the policy may be self funding).
4. Cash value growth may be able to be accessed tax-free, similar to the benefits of a 529 plan.
5. The money in the policy can be used for any reason, and the parent's can retain control even as a child gets older.
6. Getting life insurance on children can be very inexpensive.

The Cons

1. If designed poorly, you may lose flexibility for additional contributions or reducing contributions from year-to-year.
2. You may be able to achieve higher levels of growth within various investments as described above.
3. It's can be kind of morbid to think about getting life insurance on your children.
4. You are subject to the annual gift limitation for the contribution you make towards the policy.

7) Roth IRA's

The Pros

1. There is no limitation on how the funds can be invested.
2. Business owners may be able to hire their children to work in the business giving them access to a Roth IRA.
3. Money used for education expenses can be withdrawan from a Roth IRA without penalty or taxes as long as it has been in the account for at least 5 years.

The Cons

1. There needs to be earned income in order to contribute.
2. There may be taxes and/or penalties required if the funds are not used properly for qualifying education expenses.
3. Investing involves risk, and the market could have a correction right before the money is to be used for education expenses.