Updated February 2017 — When it comes to preparing to send a child to college, the sheer enormity of the experience, both financially and emotionally, can be daunting. But it's also a tremendous opportunity for a parent or grandparent to give children a powerful legacy. "The gift of education is an important priority for many of our clients," says Katherine Dean, Managing Director – National Director, Family Dynamics at Wells Fargo Private Bank. "Education provides the child with tools they need to cope with an ever-changing world, including the financial aptitude to handle future inheritance."
Patricia Armstrong, Senior Managing Director of Family Dynamics at Abbot Downing, agrees. "College is such a wonderful developmental experience," she says. "It's something to be enjoyed, and so is the preparation."
So how do you prepare in a meaningful way? And how do you plan so that the experience is a wonderful journey and not fraught with stress? "It's always a good idea to begin planning as soon as possible," says Pat Neil, Senior Wealth Planning Strategist. "But opportunities exist, and we are glad to help clients get started, even later in the game."
Talking college and talking money
The conversations around college can start any time, but certainly by early high school you'll want to begin talking with your child or grandchild about what he or she hopes for the future, as well as any aspirations of your own you may have, notes Armstrong. Not every child is interested in pursuing a traditional college route, but even those aspiring to art school, travel or an apprenticeship benefit from planning ahead.
"There are important steps for you and your child to take in preparation for college, particularly in targeting the college of your choice," she says.
Among those steps: estimating the cost. What sort of college is your child interested in attending — small, private liberal arts school or large state university? The College Board estimates current average costs for public four-year colleges to be $9,410 per year in tuition and fees for in-state students for the 2016/2017 school year. Private nonprofit four-year colleges post an average of $32,410 per year in tuition and fees. Add to this, of course, the cost of housing, food, books and living expenses, which can vary greatly depending on location and experience offered.
Increases to college cost generally mirror inflation. According to The College Board, tuition and fees at public four-year institutions increased at an average rate of 3.5% per year beyond inflation for in-state students over the 2006/2007-2016/2017 school years. That represents a decrease compared to average annual increases for the previous two decades: 3.9% for 1996/1997-2006/2007 and 4.2% for 1986/1987-1996/1997.
Another thing to think about is any plans for advanced study. The cost of applying to graduate school and associated interviews will depend on the number of schools in the consideration set and the amount of travel needed as part of the process. And the cost of a two-year MBA at most top-tier schools is likely to dwarf the cost of an undergraduate education. All of these factors play into what sort of financial planning you will do — and how you work with your child to make these aspirations a reality.
It also is important for parents and grandparents to communicate with each other about their plans and to coordinate their communications with the young adult so that all have a shared understanding of the support that each intends.
"College is such a wonderful developmental experience. It's something to be enjoyed, and so is the preparation." — Patricia Armstrong, Senior Managing Director of Family Dynamics, Abbot Downing
Setting the plan in motion
These conversations will inform the vehicle or vehicles that you may choose to help fund your child's education. There are many options, offering varying degrees of flexibility and control for parents, grandparents and students. The three main options are 529 plans (also called qualified tuition programs), custodial accounts, and trusts.
Option 1: 529 Plan "If the goal is to pay for college, there may be no better vehicle than the 529 plan," says Neil. "Your contributions can potentially grow tax free. Withdrawals also can be tax exempt if used for qualified educational expenses, and 529 dollars can be used at virtually any college or university in the country. There's just so much flexibility." Benefits of a section 529 plan include:
- While your contribution is made with after-tax dollars, it has the potential to grow tax-deferred. Qualified withdrawals are federal tax free. Another benefit is that the value of the plan is not included in your taxable estate, yet you still control the money.
- With 529 plans, there is a special provision that allows you to make a lump-sum contribution of up to $70,000 per beneficiary in a single year and elect to spend that contribution evenly over five years without incurring federal gift tax consequences.
- Married couples can contribute up to $140,000 in a single year to a beneficiary through a 529 plan without incurring gift tax, provided no additional gifts are made to that beneficiary for a five-year period (subject to recapture if the investor dies before the five-year period has passed).
- If the money isn't completely used or if plans change, you can roll the account balance to another 529 plan once per 12-month period for the benefit of the same beneficiary. For beneficiary changes to occur tax free, the new beneficiary must be a member of the family of the original beneficiary for whom the account was created — including their siblings, first cousins or even their parents.
- These plans are not limited to your lineal descendants. You can set up a 529 account for the children of your employees or a household employee. Or you can fund plans for nieces and nephews or for children in your community.
- Any post-secondary school participating in the U.S. financial aid program, including international institutions, will likely accept 529 plan assets.
- So long as they are connected to a student's enrollment or attendance, qualified educational expenses under a 529 Plan include: 1) Tuition, books, supplies, and equipment; 2) Expenses related to the purchase of computer hardware and software; and 3) Room and board (so long as student is enrolled half-time and subject to certain limits).
- If the child receives a scholarship, you may use the funds to pay for qualified educational expenses that are not covered by the scholarship. Or you may withdraw the amount of the scholarship without triggering the 10 percent penalty for non-qualified withdrawals (income taxes, however, still apply). Other options are to leave assets in the account for future use or change the beneficiary on the account to a qualified family member.
Section 529 plans can be set up in any state by anyone or by your financial advisor, but it's essential to understand the fees and cost structure associated with your plan. Some states include an income tax benefit; some have significantly higher fees. "Before you make your decision, complete an assessment with your advisor to get a sense of any state income tax benefits," says Neil. "What are the costs, and what's the performance?"
Please consider the investment objectives, risks, charges and expenses carefully before investing in a 529 savings plan. The official statement, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest.
- 529 Plans are subject to enrollment, maintenance, administrative and management fees and expenses.
- Non-qualified withdrawals are subject to federal and state income tax and a 10% penalty.
- College savings plans offered by each state differ significantly in features and benefits. The optimal plan for each investor depends on his or her individual objectives and circumstances. In comparing plans, each investor should consider each plan's investment options, fees and state tax implications.
Option 2: Custodial Account "A custodial account is another way for you to contribute toward your child's future education needs and they can get access to the money once they reach the age of majority — 18 or 21," notes Armstrong. "The advantage is that there is complete flexibility. They can spend it on a year abroad, etc. But you have less control yourself on how the money is spent."
As custodian you are responsible to see to it that the funds are used for the benefit of the minor before he or she takes control of the account, so you can use funds to pay for education costs until the child's age of majority; then the child has control. All gifts/transfers to a minor are irrevocable, and the donor retains no rights in the property. The assets cannot be used for the parents' benefit or to benefit any other sibling.
An important consideration is the question of whether you're going to support the full college experience including tuition, books, and materials; room and board; and incidental expenses. Do you think it's important for your child to earn some of the money to pay for college? This is a reflection of your values, and the values that you want to instill in your children.
Option 3: Trusts A trust falls in between the two options in terms of flexibility and control. "One drawback to establishing a 529 plan is that the recipient may decide not to go to college. If that is the case, a trust may be the better option. A trust can include specific education provisions, but may also provide flexibility for the beneficiary to use trust assets for other purposes," says Neil. "Education may be part of it, but a beneficiary may also use it for his or her health, for maintenance, support, to purchase a home, or for other uses the grantor deems appropriate." A trust enables you as the grantor to dictate the terms and thus direct how and when trust assets are used. However, a trust requires the services of an attorney and is more complex than a 529 Plan or Custodial account in terms of initial set-up and ongoing maintenance.
Even when using trust assets to fund your child's educational expenses, you can further increase the tax efficiency by making tuition payments directly to the educational institution. Tuition payments made on behalf of another person are not considered taxable gifts and therefore are not subject to the gift tax annual exclusion. As a result, parents and grandparents who already fully utilize the annual exclusion with regard to a child/grandchild can make additional tax-free transfers for tuition as well. Please consult with your legal advisor regarding your particular situation.
Conversation starters In addition to the technical aspects of funding an education, how do you deal with the emotional impact and change to your family? "Sending your children off to college is a significant milestone," says Armstrong. This is an opportunity for you as a parent to start meaningful conversations, ones that will help you convey your hopes and wishes as well as get a glimpse of your children's dreams. "What can be valuable to the child is the dialogue and making the conversations aspirational as opposed to pressure-based," says Armstrong. "So you're empowering and enabling; just in that process alone you're helping to prepare them to be on their own."
But there are also practical discussions you'll want to have. An important consideration is the question of whether you're going to support the full college experience including tuition, books, and materials; room and board; and incidental expenses. Do you think it's important for your child to earn some of the money to pay for college? This is a reflection of your values, and the values that you want to instill in your children.
Other more brass tacks considerations include:
- Budgeting, really working through realistic expenses: There is no better time to hone financial literacy skills.
- Preserving credit quality. If you give them a credit card, what are the instructions? Do they have their own and do you see the charges?
- Working toward goals. Discuss what they hope to accomplish, and how that will inform how they prioritize their time.
- Maintaining contact. Establish when and whom to call if there are emergencies, offering an open invitation to call when needed.
- Spending time wisely.
Empowerment with a safety net
You may also want to address the issue of how much contact you'll have and how much information will flow between you and your child. This is an individual decision, differing from family to family and, really, from child to child. "The benchmark for what is right is probably a little less than the current state," adds Armstrong. "It's going to be different for each person, but there should be more autonomy in college, so you want to move to that next step of autonomy."
Parents and grandparents can offer great perspective and wisdom from their life experiences, but it's also important to give young adults the ability to stretch their wings and build their own experiences. Some may discover that college is not right for them after all, or they may not make the most of the experience, partying more than studying or otherwise not finding success. This is your opportunity to coach them on accountability as well as finding their own path. It's a delicate balancing act. "Four years go so quickly," says Armstrong. "Just having conversations, planting seeds, and being open to new perspective will help the young adults prioritize."
The key is to enjoy the process and understand that it's all part of the experience of growing for all of you. "There will be bittersweet moments," says Armstrong, "but having the opportunity to support your child in a college experience is a tremendous gift."