This is a pretty decent plan in some ways, but there's a lot of limitations as well. You have a larger variety of investment options in the ESA than almost any other type of college savings plan, and so you can get a lot higher rate of a return than just putting it in a savings account and the money grows tax-free. And as long as you use it for tuition or qualified costs like room and board and books, then when you pull the money out it's tax-free.
Speaker 2:Welcome to what your CPA Wants you to Know a podcast for business owners and those planning to make the jump into entrepreneurship. If you're thinking, I've got a great business idea, but what's next? This podcast is for you.
Speaker 1:I'm Carson Sands.
Speaker 2:And I'm Taryn Sands.
Speaker 1:I'm a CPA with over 10 years of experience helping people start and grow their businesses.
Speaker 2:And I'm an MBA with a specialization in marketing and entrepreneurship.
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Speaker 2:Let's do it. We have an episode today about a topic we get many questions about saving for college. So since we have three kids, we've definitely talked about this subject a lot. Carson is back again to help explain the options for college savings and all the tax benefits to each type of account.
Speaker 1:I am so excited to be back. And, yeah, so we have three kids and all of them could be going to college, so this is a topic that's pretty important to us.
Speaker 2:So we've talked a lot about this in the past and I think my biggest concern when we're picking, like, the best account for our kids college expenses, that I just wasn't really sure that they're all going to be going to college or if that's something that I really even feel is even necessary anymore this or go to a trade school or anything that doesn't require a college education I would rather them not. I would rather just have the money and be able to help them do something else with it, start a business, put it for a down payment on their home. So I would much prefer that over them going to college just to go and waste my money, I guess.
Speaker 1:Yeah, me too. I mean, if you want to be a doctor or a lawyer, you need to go to college. If you want to be an engineer, I really want you to go to college if I'm going to drive on a bridge that you're going to design. But right, college isn't necessarily for everyone. And these days, going just to go, when so much the information you need to run a business is available out there from people like us, from all kinds of sources, and it's free, then it doesn't make sense a lot of times, and so that's something to keep in mind when you're planning ways to save for college. You want that money there, but do you want it to be trapped in something where you'll be penalized If you don't use it specifically for college? That might not be something you want, so keep that in mind as you decide how and where to save money for college.
Speaker 2:Right, exactly, I think we're both finally on the same page that, absolutely, if one of our kids wants to go be an accountant or a lawyer, a doctor or something, for sure you absolutely have to have a degree to do that, but we don't want them just to go and figure it out because it's really expensive. Now, if you don't need it, I just feel like you shouldn't get it. So it's a really big investment to make we can all agree on that and you really just have to make the best decision that works for your family and, after you look at all the options and consider the tax consequences of each, you have to make that decision. The options that we're going to discuss today are ESA 529, 529, prepaid tuition, utma and a Roth IRA. We're going to explain each of these and what the pros and cons of each are.
Speaker 1:So the first option is prepaid tuition. This is a state-sponsored tuition plan that lets you pay in advance for future college tuition at today's rate. The pro here is that college tuition is increasing every year, so locking in that rate at the current time could save you money.
Speaker 2:So basically, you're taking a gamble that it's going to be cheaper today than it's going to be when your child starts college.
Speaker 1:And it probably will continue to increase in price, but will it continue to go up at an average rate of 7% or more per year, which is what it's done for a while? I don't know if that's going to keep happening. People are getting fed up with the continuing rising costs, even above and beyond what inflation is, and getting less and less being forced to do online classes when they don't want to. Things like that are causing people to go to college less and less, and so universities might have to stop increasing prices so much, so that's one reason prepaying the tuition might not be as beneficial as you're hoping.
Speaker 2:Okay, so that sounds really good. You want to lock in today's price for college that you're going to pay many years down the road. But what is the disadvantage to this type of plan?
Speaker 1:So the disadvantage is that you could make 10 to 12% on your investments in the stock market, so why would you do something that has an average increasing rate of 7% whenever you could be making 10 to 12% in the stock market?
Speaker 2:Okay, so you're saying that it's just probably not going to keep increasing, and even if it does, you would still be better off investing that in something else.
Speaker 1:That's right, and there's a lot of other cons to the prepaid tuition as well.
Speaker 1:A lot of times you can be trapped in the state that you do prepaid tuition for.
Speaker 1:Sometimes they have deals with other states where a state next door might let you use the prepaid tuition for their universities, but I can't guarantee which states do and don't allow you to do that. What I do know is you won't have the freedom to go just wherever you want to go, or even if you want to stay in state and go to a private university, you can't always use those prepaid tuition funds for that purpose. That, on top of the fact that you're not allowed to use the prepaid tuition to pay for books, room and board or anything like that. And just to give you an idea of how important those other costs are, I'm looking at the Texas Tech University 2020 to 2021 average cost and it's showing that the average cost, before financial aid of any kind, is $27,782, but only 11,852 of that is from tuition. The other $15,930 is from books and room and board. So if you're not covering over half of the costs of your college and your savings plan, then you're not setting yourself up to have a debt-free college experience.
Speaker 2:Right. So that's a really, really big con, and one of the reasons that we don't really like the prepaid tuition plan is because most people really want to pick a plan that's going to let you use the money for other expenses too, like the room and board, because that adds up really quick. So the next one you've probably heard about is an ESA and it stands for Education Savings Account.
Speaker 1:This is a pretty decent plan in some ways, but there's a lot of limitations as well. You have a larger variety of investment options in the ESA than almost any other type of college savings plan, and so you can get a lot higher rate of a return than just putting it in a savings account, and the money grows tax-free. And as long as you use it for tuition or qualified costs like room and board and books, then when you pull the money out it's tax-free, so all of that growth was never taxed. That's a great benefit. But some of the problems with the plan are that contributions are limited to $2,000 per year and some people make too much money to qualify, and also you have to use all of the funds by the time you turn 30. And if you don't, then you'll pull the money out whatever's left at the age of 30, and it will be penalized and possibly taxed as well. So that's a lot of problems with the ESA.
Speaker 2:And also with the ESA, you can only use it for education purposes.
Speaker 1:That's correct.
Speaker 2:So if you pull it out, if you need it for something else, there's going to be a penalty if you pull that money out.
Speaker 1:Yes, that's right. You will pay a penalty if you pull the money out for anything else. So as soon as you have covered all of your college or you choose not to go to college, then once you pull that money out whether you're 30 or whatever age you are if it's not going to a qualified education expense, then you're going to end up getting hit with a 10% penalty on that.
Speaker 2:So on, the ESA is a qualified expense, also room and board.
Speaker 1:Yes, you can use the money for room and board or for books, but those and tuition are the only items that you can really use it for Now. You can also use it for some K through 12 education expenses or homeschooling expenses, and there's also some technical colleges and training programs that you're allowed to use it for as well. So even if you decide college isn't for you, that doesn't mean that you won't be able to use the funds somewhere.
Speaker 2:But it is still a pretty limited account.
Speaker 1:Yes, and one of the biggest limitations is the $2,000. I mean it might be enough if you're going to a cheap school and you start saving the second your kid is born and you're doing 2000 a year. But I mean really, if your kid is getting close to college age and $2,000 a year that's just not going to cut it.
Speaker 2:So one of the biggest disadvantages of the ESA for a lot of people is the income limitations. So can you tell us exactly what the income limitations are for the ESA plans?
Speaker 1:If you're single it's $110,000. And if you're married it's $220,000. So if you make over that, you can't use the ESA.
Speaker 2:Okay, so that definitely means that there are a lot of people out there that can't use that account. So we're going to talk about the next type of account, and that is a $529. A $529 plan is a tax advantage college savings account sponsored by the state, government or education institution. There are two types of $529, the $529 savings plan, which we're about to talk about, and the $529 prepaid tuition plan that we talked about earlier.
Speaker 1:that we're not huge fans up yeah, and so here's some perks on it. Just like the ESA, the money you invest into the $529 savings will grow tax-free when you pull it out for college purposes. There's no taxes on the amount you pull out, so all of that growth never gets taxed. So you can grow a lot of money inside of $529 because there's all kinds of plans through Fidelity or Vanguard that are $529 type plans and you invest in those, very similar to how you invest in a retirement plan. So there's no restrictions on who can contribute. So the grandparents can contribute money for the kids or aunts and uncles there's really no limits or just a rich friend that wants to help your kid go to college. That's another part that makes it so great. There's not really income restrictions on the $529 savings. There's also not a max on the amount that you can contribute each year.
Speaker 2:That's really good. So there's no income restriction, so anyone can use this type of account and there's not a cap on how much you can contribute, and everyone in your family that wants to can contribute to the account.
Speaker 1:That's true. So there's not an annual limit, there is a total lifetime limit and depending on which state and which $529 plan you're talking about, it can be between $250,000 and $550,000. For most of us that's going to be plenty of money, between the actual contributions and the growth on that amount, to pay for just about any college you want to go to. If you're looking at Ivy League, you know that might be an exception, but the limit's so high that it's not going to matter to most people.
Speaker 2:Okay, one thing that came up, I know, when we were discussing college accounts for our kids, is that if you have one and you put it in the name for, like our oldest child, what if she doesn't use it? Can you change it to a different child? Can it be for anyone with the $529? You do have the ability to change who it's for, but is that for every type of account?
Speaker 1:Yes, let's talk about that. That's something you can do with the $529. And let's talk about all the things you can do. If your, let's say, your oldest kid doesn't need to use the money for college for some reason Either they get a full ride or they're just not going to go to college you can transfer that to the next kid in line. That's one of the options. You can also take a $529 that doesn't get used and you can start rolling it into a Roth IRA for the student that you were planning to send to college. So you can do $6,000 per year until the day all of the money in that $529 is depleted and it will all go into a Roth IRA. And since the money was contributed after tax and Roths are after tax type accounts, then the money will continue to grow tax free and when it's eventually pulled out in retirement, it will get pulled out tax free.
Speaker 2:So that's a really huge benefit. If, for some reason, you don't end up using that for your child's education, they could just get a jumpstart on their investing for retirement.
Speaker 1:And you might be thinking well then, won't that take care of the $6,000 that they're allowed to contribute to the Roth IRA each year? It will. They won't be able to contribute while they're rolling $6,000 per year into the Roth from the $529. But there's plenty of other retirement savings options that they'll be able to use, since they're already maxing out that $6,000.
Speaker 2:So really the only significant drawback for the 529 is that if you withdraw the money for anything that's non-educational, then you have to pay the penalty whenever you take that out.
Speaker 1:That's right. So if they don't use it for college and you don't want to roll it to a Roth IRA for some reason and you start using the money because of emergencies or for any other reason, then you will get hit with that 10% penalty.
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Speaker 2:Now back to the show. Okay, so the next one we're going to talk about is the UTMA. The UTMA is just an acronym for Uniform Transfers to Minors Act, and it refers to a law that allows a minor to receive gifts without the aid of a guardian or trustee. So an UTMA account allows a gift giver to manage the minor's account until they're of age. It also shields them from tax consequences on the gift. The account is in the child's name, but controlled by a parent or guardian until the child reaches either 18 or 21. This plan is different from the ESA's and 529 plans we talked about, because it's not just for saving for college.
Speaker 1:So the UTMA can be used for a lot of different things. I like to think of it as a trust light kind of, because it doesn't have nearly the kinds of fees and complications of setting up a trust. You don't even have to use an attorney, you can just go to a bank and open a savings account. That's an UTMA, but it is similar to a trust in that you have control over those funds but they're for the benefit of your child until they reach a certain age. So saving for college in one of these is a reasonable plan. If you think there's a chance they might not even need it maybe they're going to get a full ride, or maybe they're not going to go to college well then, that money is sitting there for whatever they need. If they have some great business idea and they want to start it when they're 19, you can use the money for that and there won't be a 10% penalty. So there's some perks to using the UTMA. The reason you would use that instead of just setting the money in a savings account, for example one. It guarantees that it goes to that child. Once you put it in there, it belongs to the child, even though they don't have access to it until they reach the age of the majority. It's still there. You can't use it for yourself.
Speaker 1:There's other benefits to it. If you're in a really high tax bracket, then the money is taxed at the child's lower tax rate. So some things that I don't like about it. As much is there's not nearly as many tax benefits to this. The growth is not going to be tax free. It might be taxed at a slightly reduced rate, which is the child's rate, but it will still be taxed. And if they make too much income it will get taxed at your own higher parents rate anyway. And you can't change the beneficiary once you select one. So let's say your oldest kid doesn't end up needing the money, not only that, but decides to become a heroin addict. You can't just change the name or the beneficiary to the next kid in line like you can with some of those education savings accounts or 529 savings, so that money is going to go to that kid and they might use it to buy more drugs, and that can be a pretty big problem if you don't want them to have that money.
Speaker 2:Drugs or more PG things like a new car, things that maybe you wouldn't want them to use the money for.
Speaker 1:Right, but if the age that they get that money is 21 in your state or 18, then the day they turn that age they can use that money for whatever they want.
Speaker 2:That seems a little scary to me, just saying with three kids.
Speaker 1:Me too. The small tax savings that you get from this option really, to me, aren't worth it. I would rather you just save the money in your own investments or your own savings accounts and give it to the kid when they reach that age.
Speaker 2:So setting up an UPMA is basically like setting up a trust for your child and it definitely offers some benefits for you, being able to use it for whatever you want. But the tax benefits just really aren't there and we both are a little afraid of having all that money set aside for our kids and having them take control of it at 18 or 21, because that seems pretty young.
Speaker 1:If you would have given me $100,000 when I was 18, it would have ruined my life.
Speaker 2:Yeah, I definitely can say I wouldn't have used it wisely either at that age. That definitely scares me for them to have a big chunk of money at that age. The last one we want to talk about is contributing to a Roth IRA for college savings. So a Roth IRA is just an individual retirement account that offers tax-free growth and tax-free withdrawals in retirement. Roth IRA accounts are funded with after-tax dollars and grow tax-free, and the money can be withdrawn for educational purposes without penalty.
Speaker 1:So here's the pros and cons for the Roth IRA option for saving for college. There's a lot of similarities to the 529 savings, even though the Roth isn't necessarily intended for college savings. Since you're allowed to pull the money out for college, like Taryn mentioned, then you can always use this as an option. So the money grows tax-free, just like it does in the 529 savings, and when you pull it out for college, you pull everything out tax-free, including the growth, and there's no penalty as long as you're using it for college. Some of the limitations are that you can only contribute 6,000 per year, and another really big limitation, and a pretty important one, is that your kid actually has to make $6,000. You can't contribute your own earnings to someone else's Roth IRA. So this actually ties into one of our previous episodes where we talked about the tax benefits of paying your kids to work for you. Well, you can pay them and then turn around and force them to contribute the money to a Roth IRA, and then they can use that for their own college savings.
Speaker 2:Right. So in that situation, if you do listen to that episode that we have about paying your kids, you can only contribute to an IRA if you make an income. So in that case you would be paying your child, so they would have an income, which would allow you to use this account.
Speaker 1:And so you might be wondering well, why would I do this instead of a 529? You would use a Roth IRA instead of a 529, because if you don't end up using the funds for college, instead of just being able to roll $6,000 per year like you could roll in the 529 into a Roth. You would already have the Roth account set up and ready to go and you could continue to contribute, or your child could continue to contribute to the retirement plan on an ongoing basis as they join the working world.
Speaker 2:So this is a really good plan but probably wouldn't be used by anyone that's not a business owner that's trying to pay their kids just to get that extra tax advantage. But it definitely has a lot of uses and no penalty if you want to use it for college. So one of the biggest questions that we get whenever we're talking to our clients about all of these options is where would one go to open up these type of accounts for their child? You?
Speaker 1:can do it online. You can go to Vanguard or Fidelity on their websites and you can open a 529 just through their website.
Speaker 2:So would you advise using someone to help you go to your financial advisor, or is it just simple that go online to the bank's website and click which one you want?
Speaker 1:That's a great question. I would advise you probably do use a financial advisor If you are a very financially savvy person who could handle this on their own. Then you probably did not listen to this episode because you probably already knew all the information in it.
Speaker 1:So if this is all new information to you, then it might not be the best idea for you to manage this all on your own. Using a financial advisor the same kind of person you would use for retirement is going to be a great option. They'll pick very similar investment strategies that they would use for your retirement plan and, yeah, so I would definitely call your trusted financial advisor.
Speaker 2:And this is just such a huge decision. For every single family this is going to be different. So you're basically just trying to look into the future and see what your family is going to be like, what you think may happen, and making a decision based on all of that information. So your job really is to look at all of these options and decide what you think looks best for your family and then go to your advisor and say you want to open this type of account and you just need to know all of the details of the account. You need to make sure that you know the tax consequences and that you're not signing up for something that you really truly don't know anything about. So another big question we get is when should you start? When should you start investing for college, for your kids, and if you haven't already, is it too late?
Speaker 1:It's never too late, but the earlier you start, the more you'll get to take advantage of time value of money. So I've run the numbers and if you start the day your kid's born and they go to college when they're 18 and you invest in the stock market and it's making about 10% returns, so this would be through the 529 savings option, the ESA or through the Roth IRA option. If you're doing that, then by the time they're 18, about two thirds of what's in that account will be growth and only one third will be the money you actually put in. So you're allowing the growth in the market to pay for two thirds of your kid's college expenses. And all of that growth and income is tax-free. So that's a pretty great option. So if you start later you're not going to have nearly that much growth, but any little bit helps. Any amount that you can get investments and interest and earnings to pay for instead of your own pocket is a really good thing.
Speaker 2:So definitely start as early as possible, but don't feel bad if you haven't started already. You can start one of these today and you're still going to have some growth along the way.
Speaker 1:Absolutely.
Speaker 2:Okay, so we touched just a little bit about all of the options that you have, which are prepaid tuition, esa 529, atma and a Roth IRA. We gave you a little bit about what each of those plans are and the pros and cons of each, and why we like each one and which ones are our favorite.
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Speaker 1:This podcast is intended to provide accounting and tax information for educational purposes only. These situations are unique and should be handled with the assistance of a tax professional.