College Planning in an Age of Uncertainty

One of the most important undertakings facing new parents – and grandparents – is planning and saving for the future educational expenses of the family’s new addition. As a new parent myself – of twins no less – it has become remarkably clear how expensive school will be in several years. As an example, the current annual cost of attending UNC Chapel Hill – including tuition, room/board, and fees – is nearly $24,000. Assuming an annual inflation rate for college expenses of 6% (which is less than the historic average), the projected total cost for four years of undergraduate education will be roughly $300,000 in 18 years. For an in-state school.

Fully paying for this cost would require either a lump sum investment of $116,000 today or $627 each month (increasing annually for inflation) until college begins, assuming an annual return of 5%. Of course, while these expenses may be partially covered through annual cash flow, financial aid, and loans, it is still a mind-boggling amount of money to think about.

529 plans are the standard vehicle to save for college expenses due to their tax efficiency and flexibility. Contributions to 529 plans are made using after-tax money but the growth of contributed assets accumulates tax free and distributions for qualified educational expenses are not taxed. It is important to note that North Carolina residents are not restricted to using the  North Carolina plan. We have helped clients identify plans that are best for them with low costs and a good investment selection.

A drawback to the 529 plan is that it “locks in” contributed assets for education. Funds that are not used for qualified educational expenses will be taxed as income on their growth when withdrawn, along with an additional 10% penalty. Because of this, we often recommend that clients use a variety of accounts when saving for college. One alternative is a Roth IRA. Roth IRAs allow you to withdraw money for qualified higher education expenses before age 59.5 without incurring the 10% early withdrawal penalty. Note that investment growth (but not principal) withdrawn from a Roth IRA will be taxed if the Roth has been open for less than 5 years. To be eligible to use this IRA distribution for higher education, expenses must be for yourself, your
spouse, your child, or your grandchild.

Money in retirement accounts such as IRAs is exempt from being evaluated on the FAFSA for financial aid. Keep in mind that when IRA funds are withdrawn for education expenses, the funds count as income the following year which could impact your financial aid. Therefore, Roth funds are best used for a student’s senior year.

If you do find yourself in the situation with extra funds in your 529 plan, there are several options for using the funds without incurring penalties and/or taxation aside from changing the beneficiary to another family member.

The SECURE act (passed in December 2019) allows the funds in 529 accounts to pay up to $10,000 per child toward a student’s—or parent’s—student loan debt penalty and tax-free. This provides some flexibility to allow for loans to temporarily cover expenses if otherwise a distribution from the plan would need to be taken at a loss in a given year. In addition to undergraduate education, 529 plan funds can also be applied towards most graduate programs and – thanks again to the SECURE act – the expenses related to some apprenticeship, trade school, and vocational programs. On a related note, the Tax Cuts and Jobs Act (2017) allows families to use 529 plan funds for private school tuition for younger children, up to $10,000 per child per year.

To throw another wrench into the education planning process, the COVID-19 pandemic has led many universities to switch to online learning—or cancel classes altogether. Many students and parents received partial or full refunds of tuition, room, and/or board expenses from the universities. Any family member who receives tuition reimbursements from institutions paid from 529 plans should recontribute the funds to the 529 plan. To avoid taxes and a 10% penalty on any gains, funds received must be redeposited into the plan for the same beneficiary within 60 days.

Planning for higher education and its associated expenses is always a complex and expensive challenge, made even more so with the disruption brought about by the COVID-19 pandemic. Fortunately, 529 plans – enhanced by recent regulations with additional flexibility – have provided parents and students with a helpful option to address the financial impact of this challenge.