Why saving for higher education matters

Having kids of my own I realize I have 18 years to either plan for my children’s college education or hope they will be talented enough athletically or academically to earn a scholarship. A meager 2% of high school athletes will earn an athletic scholarship,^1&2 whereas the amount of student-athletes who receive a full-ride scholarship for a sport is much less than 2%. What is even more eye-opening is that only 0.30% of students earn enough scholarships and/or grants to cover the cost of college.³

If our sons and daughters are not in the top 2% of all high school athletes then they will need to have a top GPA from high school to earn significant academic scholarships. Scholarships are so competitive that only 19% of high school students with a GPA between 3.5 and 4.0 earn a financial scholarship based upon merit.⁴ These merit-based academic scholarships that are given out typically average around $2,800.00 per year.⁴ Keep in mind that on average it costs $26,590 for a public school with in-state tuition per year, $42,970 for a public school without state tuition per year, and $53,980 for private school per year.⁵ Thus even if your child is well above their peers academically the amount they may earn in a merit-based scholarship from their GPA and high school performance may not cover 15% of the costs needed to pay for college.

According to a 2020 Forbes article, between 1985 and 2018 the average cost to attend a four-year university rose at more than twice the rate of inflation..⁶ What this boils down to is that even if the money you are saving for your child’s college education keeps up with inflation (consumer price index) which also hovers around 3% per year, to merely keep up with the rising costs of college you should be earning a return of at least 6.1% on any money you invest.⁷

These disconcerting statistics are meant to help all of us understand the costs of college and take action now, as parents or family members of future students. By taking action early, it may take a large burden off of our shoulders when our children reach college age. In addition, planning will help allow our children to focus on their academics and help limit the amount of time they spend working to pay for college. In my experience students either drop out or do not pursue difficult and meaningful degree programs when they are juggling too many tasks outside of their studies.

When I was teaching at the University, I had a student working 30 hours a week at Costco’s tire center, taking a full class load, an active cadet in the AFROTC program, and majoring in physics. Needless to say, the 30 hours a week at Costco didn’t last long due to the competing demands of school. Many students are unable to get through a degree program when they are trying to find enough time in the day to attend class, study, work part-time, exercise, and make friends when they are not sure if they will be able to pay for next semester’s tuition.

Let’s discuss some of the options that are available to start planning for our children’s education. In an effort to maximize compound interest and allow our children to attend the school that aligns with their goals and ambitions best, it is imperative to put a process in place immediately.

Tax advantaged college savings accounts: 529 plans

Most Americans interested in saving for college are familiar with a 529 plan. The primary benefit of a 529 plan is that earnings are not subject to tax if distributions from the 529 plan are used to pay for qualifying educational expenses. The money contributed to a 529 plan is with after tax dollars. 529 plans offer different investment options and will typically include fees and other expenses. As an example, let’s say you had your first child when you turned 30 and you invested a total of $10,000.00 of your own money over 18 years; let’s also assume the $10,000.00 in the 529 plan grew to $30,000.00 over those 18 years. At age 48 you are able to use the $30,000.00 on qualifying educational expenses without paying any tax on the gain you made over the 18 years in the 529 plan.

Qualifying educational expenses include:

• Tuition
• Books
• Supplies
• Room and board, if attending at least half-time
• Equipment needed for the course of study
• and, certain fees,⁸

An added benefit of a 529 plan is that there is no age limit that dictates when the beneficiary must start utilizing the money. A 529 can be one way to consciously put money into an account that is separate from a typical checking or savings account and has the added benefit of growing tax-free if the money is used on qualifying education expenses. Some states, including Colorado, provide a state income tax deduction should you use their state-sponsored 529 plan.

There are a few downfalls to utilizing a 529 plan.

There are a variety of expenses a student will incur during their time in college that do not qualify as an educational expense. These expenses which do not qualify for favorable tax treatment include but are not limited to some room and board expenses, insurance, medical expenses, transportation, travel, gym memberships, living or family expenses.^{8, 9 & 10} If your child decides not to attend college or you need to use the money within the 529 plan for something other than qualifying educational expenses the earnings will be taxed as income according to your applicable tax bracket and a 10% federal penalty tax will also be added. The 10% penalty may be avoided if the beneficiary dies or becomes disabled, the student attends a US Military Academy, the student receives a scholarship, or the student receives assistance through a qualifying employer program.¹¹

Another downfall of 529 plans are that earnings utilized on anything other than qualifying educational expenses will be taxed as income rather than capital gains. By being taxed as income it means that you are unable to take advantage of the long-term capital gains tax rates which are lower than income tax rates.¹² This is a good reason why the funds in 529s should only be used for education expenses.

Another point to make is that the investment options are also limited in a 529 plan. Where a normal investment in a brokerage account allows you to invest in many different equity and fixed income investments a 529 plan has limited options which is based upon the specific plan itself. Furthermore, you are paying fees for limited investment options. Different investment options outside of a 529 may provide a higher return than the investment options within a 529 plan.

The question one must ask is whether the tax advantage of a 529 plan outweighs the return you could make in a different investment not offered by a 529.

There are contribution limits on 529 plans. As of January 2021, each contributor to the 529 can contribute a maximum amount per year of $15,000.00, or $30,000.00 for married couples. Alternatively, you can make a lump sum contribution of $75,000 per person to the 529 plan and elect to spread the gift evenly over a five-year span.¹³

Retirement accounts: IRAs

The IRS allows for distributions from an individual retirement account penalty-free but not tax-free if those distributions are utilized to pay for qualified education expenses.

If you withdraw from your Roth IRA to pay for qualified education expenses then the distribution to pay for college should be the principal investment and not earnings. This will allow you to avoid paying tax on the distribution. This is because you can always withdraw your contributions tax-free but beware it will impact your retirement goals.

Keep in mind that distributions from IRAs to pay for college will come into play when determining financial aid packages. This is because distributions from an IRA count as income. Thus a distribution from an IRA will lower the availability/amount of financial aid a student can receive.¹⁴

Taxable investment account: Brokerage account

The benefit of using a taxable investment account: Within a taxable investment account you are able to control whether the money goes into individual stocks, mutual funds, Exchange Traded Funds (ETFs), Bonds, Real Estate Investment Trust (REIT), and more.

Able to use the money including principle and earnings without penalty on anything you would like. The stipulation is the requirement to pay capital gains tax on the earnings portion.

• The IRS code stipulates that long term capital gains tax is 0% if you are married filing jointly and your income is less than $80,000.00. For married couples that make between $80,001.00 to $496,600.00 long term capital gains tax is 15% on earnings.

Example:

A) A family invests $20,000.00 in a 529 plan for their child’s education; over 18 years the account grows to $40,000.00 including the earnings. No tax on earnings when used on qualified education expense.

B) A family invests $20,000.00 in a taxable investment account for their child’s education; over 18 years the account grows to $40,000.00 including the earnings. If family makes more than $80,001.00 but less than $496,600.00 per year then the family is subject to 15% long-term capital gain tax on the earnings. Family will have $37,000.00 after capital gains tax to pay for child’s education.

A key distinction between a 529 plan and an investment account is that a family may be able to earn more through an investment account over 18 years than a 529 plan due to the flexibility of investment options in an investment account. However, the family may lose more as well due to the risk you are able to take in a traditional investment account versus a 529 plan account. Again, is control and flexibility a priority for you and your family? If so, perhaps an investment account rather than a 529 is in order.

• When deciding between a tax-advantaged education account (529 plan) or investment account you should ask yourself the following questions; do you want more flexibility on how you can use the earnings from your account? Earnings in a 529 plan are subject to income tax if you do not use them for qualified education expenses. Income tax is higher than long term capital gains tax. As a reminder, long term capital gains tax applies when an investment is held at least 12 months then sold.

Savings account

A traditional savings account or money market account is usually a vehicle used for near term purchases and expenses. However, with a savings account, over time inflation and the concept of Time Value of Money can eat away at the amount within a savings account.¹⁵ By leaving money in a savings account for an extended period of time you are foregoing what the money may be able to earn in the stock market, U.S. or Corporate Bonds, and many other interest-bearing investments. By putting your money into something such as a S&P 500 index fund you might expect to earn, on average, 8-12% per year over a long-term span. Since the inception of the S&P 500 in 1928 through 2019 the S&P 500 has returned, on average, just under 10%.¹⁶ After accounting for inflation you could expect to earn 7% per year on average not including taxes and fees. We must keep in mind that past performance isn’t always indicative of future performance. The average savings account rate of return is 0.07% for the week of December 30, 2020.¹⁷ While some banks may offer a higher return on your savings account, most banks do not offer a return that keeps up with inflation. Savings accounts are great for having money that is very liquid and needing to be spent within the very near term but for long-term savings, for college, it may be prudent to look elsewhere to save.

Certificate of deposit (CD)

A CD is a savings certificate that locks up your money for a specific amount of time and provides you a specified fixed rate of return. As of December 2020, a 5 year CD provided around 1.0% annual percentage yield.18 CDs also provide compound interest. Another benefit of a CD is that although the return might be relatively low, the money is typically FDIC insured. A downfall of most CDs is that you cannot take your money out prior to the maturity date. If you choose to take your money out before the maturity date you will be subject to penalties which will eat into your earnings and may also eat away at the principle. Another downfall is that a CD may not keep pace with inflation.

Next step

Starting early can make a mountain of difference. To discuss the different options available and review your family’s specific situation give me a call today at 303-541-2337 or email me at chad.sheiner@rbc.com.