August 3, 2022

How to prioritize college planning when it competes with the rest of your financial plan

Next to planning for retirement, planning to pay for children’s education is generally the biggest goal we see clients have, and to some, it is even more important than retirement.

A lot of clients want to work well past normal retirement age, but certain protections end around age 65 (such as disability insurance). We generally recommend prioritizing:

  1. First make sure you have proper risk management and emergency funds in place.
  2. Make sure you have a financial independence plan on track by age 65 (even if you plan on working until age 75, make sure this is because you want to, not because you have to).
  3. Then develop a philosophy and plan to fund college for kids (or partially fund if you want them to have skin in the game).

The reason we recommend planning in this order is because you can take a loan for almost anything, but you cannot take a loan to “Retire” especially if you are forced into it because of a health condition. The best way to take care of others is to sometimes take care of yourself first.

With the cost of college tuition rapidly increasing, it is important to have a gameplan to fund college in the most efficient manner possible.

Looking at the cost of a private college, for example, the price has increased by 144% over the last 20 years. In 2002, the average cost of one year at a private college was $17,938, and in 2022, that number has increased to $43,775 per year. This is an increase of 7.2% per year.

Assuming 4 years of undergrad and 4 years of post-grad at a private school (and increased by 7.2% per year), a child going to college in 2022 would need $480,561 to fully fund their education. If college is 10 years away, a total of $883,493 would be needed to fully fund 8 years at a private college.

The most popular account is a 529 plan. A 529 plan is an investment account that is funded with after-tax dollars, all the growth accumulates tax free, and can be taken out tax free if used for a qualifying education expense. 529 plans are state sponsored, and vary depending on what state you live in. Some states offer a small state tax deduction on contributions. For example, Pennsylvania offers a 3.07% state tax deduction on contributions, and any state that offers a 529 plan can be used.

If $100,000 is contributed into a 529 plan, it is invested and grows to $200,000, all $200,000 can be used for qualified education expenses tax free. If it is not needed, it can be passed to an eligible family member tax free if used for qualified educational expenses. If you decide to take the money out and not use it for college, your contributions of $100,000 come out tax free, and the growth of $100,000 is taxed at your federal income tax rate, sometimes state tax depending on the state, and a 10% penalty. So, if you are in the highest tax bracket, would pay a total of 47% in taxes (and higher if subject to state taxes) on the growth if it is not used for education expenses. This is done on a pro rata basis (between basis and growth). You cannot decide to just take your basis out and leave the growth in (if not using for college).

If money is saved into a 529 plan, the child gets a scholarship, and the money is taken out and not used for education, the growth is taxed but the penalty is avoided. For example, if $100,000 was contributed into the account, and it has grown to $200,000, 37% would be paid on the gain of $100,000, leaving the parents with a total of $163,000 after taxes if withdrawn. You are eligible to take out dollar for dollar on the amount the scholarship was worth so this example assumes the scholarship was also worth all 200k.

Contributions align with the annual gifting exclusion, so a married couple could contribute $32,000 per year ($16,000 gift per spouse) into one child’s plan. You can also choose to make a 5-year accelerated contribution in one year. So, a married couple could contribute $160,000 in one year ($80,000 per spouse) into one child’s plan, but then cannot contribute for the next 5 years (without using their lifetime exemption). It generally makes sense to take advantage of this if there is a long runway until college to take advantage of the tax-free growth, and assuming you have the cash to make this big of a contribution.

Other options for college savings are UTMA or UGMA accounts. They were originally called UGMA accounts in the 1950’s when they originated, but most states now call them UTMA accounts. UTMA account contributions also fall in line with the gifting exclusion, so $32,000 could be contributed by a married couple per year for a child. Since the UTMA accounts are in the child’s name, they are listed on their FAFSA, which would impact their financial aid eligibility. One of the major drawbacks of these accounts is that once the child is an adult (ranges from 18-25 depending on the state), they can take the money out without the consent of the parent or owner (vs in 529 plan the parent is the owner so they control when/how the money is used). Because of this and UTMAs being included on a FAFSA, we generally do not recommend these accounts to clients.

Using the example above of college being 10 years away, and the total amount needed is $883,493, let’s look at the most efficient way to save for college.

Our philosophy at EWA is to split the expected need between a 529 plan and a taxable investment account. This way, if you are planning for 8 years of college, there is a high likelihood that 50% of it will be needed for education. In this example, if the child decides not to attend graduate school, the rest of the money can stay invested in the investment account and can be used for other financial goals without paying a penalty.

In this example, the target would be to have approx. $440,000 in the 529 plan to fund 50% of the expected $883,493 cost of college. We would recommend the client to max out the 529 plan (assuming they are married), making contributions of $32,000 per year. Assuming a 6% rate of return for 10 years until the child is 18, this would put $439,086 in the 529 plan at the time of college. An additional $35,000 (factoring in capital gains taxes on growth) per year would be recommended to be saved in a taxable investment account to cover the other 50% if needed. The extra $3,000/year is needed in the taxable account because of the capital gain tax that would be subject to the growth for the taxable account.

Best case scenario for the 529 plan is that it is used for college and the entire balance of $440,000 is tax free. Worst case scenario if none is used for college is that the contributions of $319,920 comes out tax free, and $75,074 of growth (assuming 37% tax bracket, 10% penalty, and no state tax), for a total of $394,994 back to the parents.

Compared to if the same amount was saved into a taxable investment account, whether it was used for college or not, $410,674 would be the after-tax balance (assuming 23.8% capital gains taxes).

Having savings in each type of account is a great way to split the difference to maximize flexibility.

This breakdown also allows for insulation from market downturn at the time of college. As this child gets closer to college, we would reallocate the 529 plan into more fixed income, (the growth in 529 plans is tax deferred, so this is the optimal account to hold bonds). Since 529 plans should be used for college to avoid taxes and a penalty, they can draw on it for undergrad first. The taxable investment account could be left invested in growth-oriented funds (for maximum asset location and tax efficiency) and used for postgrad if needed. If the 529 plan is used up, and the market is down, the child could take out student loans and pay them off from the investment account once the market recovers. You are not able to use funds in a 529 plan to pay off student loans without paying taxes and a penalty.

College planning should be personalized based on your family’s values and philosophy but having a sound plan can allow you to make sure your goal of funding college is on track. Balancing tax efficiency and flexibility we have seen as a commonality in most meetings that have taken place at EWA.


Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.

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