Saving Too Much for College
By Michael T. Domingue, CFP®, MBA
As a parent, you want your children to succeed and soar to great new heights. A large part of this would be planning for their future and setting them up for success. There are many ways to do this, but a popular method is by saving for their education, specifically setting up a 529 college savings plan. The cost of higher education seems to increase every year so gifting your kids the ability to graduate debt-free will put them in a better financial position than many of their peers. However, parents can over-fund their 529 plan and risk incurring taxes and penalties. Please note that there are several tax-advantageous ways to save for education but for the sake of this piece we will look closely at 529 plans.
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code. These 529 plans operate like Roth IRAs, contributions are made with post-tax dollars and can grow tax deferred. Withdrawals can be made tax-free if they are used on qualified education expenses. If your savings exceed the cost of what your education expenses end up being or your child ends up receiving scholarship money that you didn’t plan on, then you could pay taxes plus a 10% penalty on the difference.
To ensure you aren’t over saving, consider only saving 75% of what you need. If you anticipate your child’s higher education expenses will be $100,000 throughout their time at college, save $75,000 and invest the remaining amount in a different type of investment account. This allows you to have the bulk of their educational expenses saved while not paying any penalties. If you have already saved more than you need, you can name another beneficiary for the account (anyone in the original beneficiary’s family) or consider waiting to see if your child pursues an advanced degree. Another route is to have this money accumulate tax-free as an education account for future grandchildren.
In addition to higher education expenses, up to $10,000 of your 529 plan can be used for tuition expenses for K-12 private schools.
Does another family member have student loans? Another use for leftover funds is the ability to repay up to $10,000 in qualified loan debt.
Make sure to coordinate with relatives to make sure they aren’t also saving and setting aside money for your children’s college expenses. Communicating your savings strategy can help ensure that money is not over saved and then taxed later. An easy way to have this conversation is around your child’s birthday. Instead of asking for gifts, ask relatives to contribute directly to the 529 plan you have set up. If you have relatives who would like to put money aside for educational purposes, consider a different type of savings or investment account that avoids penalties if not used for education.
There are many ways to build a comprehensive college savings plan for your kids and avoid taxes and penalties along the way. College is expensive but can change the course of your child’s future. Make sure you are working with a financial professional who can help you save just the right amount, in the right way.