College Planning: Breaking Down the Best Accounts and Strategies

Welcome to EWA’s Finlyt podcast. EWA is a fee -only RIA based at Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you.

And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time. This week’s podcast, I’m joined with Chris Pavcic, who is a wealth advisor here at EWA.

And we are going to take a deep dive into college planning, why it’s important to plan for college, for kids that are going, that have aspirations of going to higher education, parents that want to help, general philosophies, what accounts should or shouldn’t use, how their tax, how they work, and really just take a deep dive into the context of our philosophy and recommendations.

So Chris, let’s just dive in. What’s a general overview of how clients that you work with prioritize college planning and some of their just general philosophies? Yeah, I would say this is definitely a popular topic with our clients if they have kids, maybe even if they have other family like nieces, nephews, grandchildren, college or education comes up at some point.

I would say hand in hand with retirement and financial independence, this is generally a top goal for a lot of the people that we work with. Yeah, I would say some people, this is even more important than working, for financial independence, they’ll work longer to pay for their kids’ education.

So what generally do you think people, what’s a common philosophy that we have, paying for undergrad, paying for post -grad, helping it not at all, what’s the most common way to approach it? Yeah, most commonly we hear parents wanna do the best for their children and…

And most of the time say that they want to foot the bill and cover that cost, but it does vary from client to client. For example, if we work with a doctor maybe that had student debt coming out of school and getting into residency, maybe they have a different attitude towards it and want the kid to have some skin in the game.

But ultimately, each client’s a little bit different. But I would say more often than not, we’re planning to try to cover the full cost for the kids. So I would say first tip is as a family or a couple or even single spouse doesn’t matter.

Develop a philosophy of what you want college to look like. Some people don’t want to pay for any and they want their kid to have total skin in the game. They’re on their own for funding it. Some people want to pay for half of undergrad and anticipate the other half that the kid pays for, takes out loans and any postgrad they would not cover.

Some people want to pay for all of undergrad and if they go to postgrad it’s on them and some people want to pay for years of undergrad. four years of post -grab. Obviously, that can make a huge difference in your financial plan, because those are some big numbers that you’re talking about, which we’ll go through in a second here, especially with the rising cost of college.

I would say too, a lot of it stems from how the parent was, how they got through college. If they paid for everything themselves and they thought that that helped them out and get to where they are, sometimes they’ll want their children to do the same thing, or vice versa.

If they paid for everything themselves, they may there was a terrible way to do that and they want to help their kids. It varies, but I think a lot of it has to do with how they paid for or how they got through college.

Absolutely. A lot of the time, we’ll get the feedback from clients that they want to help but not enable and don’t want to see motivation tear off if the kid knows that they don’t really have any skin in the game.

We’ve even had a lot of clients. I know personally, I’ve worked with a lot of people that say, I want to help them, but I don’t want my kid to know that I’m helping them. I want to be the bank and have the kid going through school as if they’re taking out these student loans, or maybe not taking out the student loans, but thinking that they’re going to have to pay this cost eventually.

Eventually. That gives them the motivation to take it seriously and not party all the time or goof off during school. I think too, a lot of what I hear from clients is it depends what the kid wants to go to school for.

If the cost of a tuition is worth the degree that could have a huge impact to taking out a lot of student loans for a degree that has a lower income, obviously, it’s a big financial decision versus taking out a lot of school loans to go be a surgeon where you’re going to be making a high income.

For sure. I think before even talking about how to plan for college, I think one of the most important things is having those discussions with the student and setting realistic expectations of why are we going into school because that’s the that’s the path that everybody says you should follow or are we going to school to pursue a passion.

So I think knowing what you’re studying and what that outlook looks like after school is very important to should be step one in the planning process. Yeah, I think that’s so important to be intentional.

And just, yeah, having an understanding of the, you’re right, it’s very, as you’re going through high school, it’s kind of like, hey, it’s like a norm of you should and have to go to college. But I don’t, I think there is a very, there isn’t a very clear understanding from a lot of people of like, hey, when you take on this large amount of debt, what does this actually mean for you when you get out?

What’s your income going to look like? And yes, I think that’s super important to have a clear understanding of that with with the child and have this conversations. But let’s just talk about the caught the landscape of higher education.

So basically, the landscape is costs of college are rising asianically. A lot of differing philosophies, will college be free in the future? Will people stop going to college? Will people go towards more trade schools?

Who knows? But what, Chris, talk a little bit about how much has college actually risen over the last 20 years or so? And then what’s like a project, if you’re planning for with a client and their kids one years old or a newborn, what do you expect the cost to be in 18 years?

Yeah, so we have the data here. So over the last 20 years, college tuition has risen an average of 7 .2% per year. Wow. So if we look at going back to 2002 for private college, the average cost was $17 ,938 per year.

And then 2022, that cost was $43 ,775 on average. So it’s over doubled. Yeah, so 7 .2% per year increase over the last 20 years, but the cost over that timeframe has risen 144% over that 20 years. That’s crazy.

So my professional opinion, I don’t think that that’s sustainable to continue. Something has to give, people will stop going to school, kids will not, I don’t know, something has to happen. Colleges will raise, decrease tuition.

So when we’re planning, do you, what’s a good inflation rate that you generally will use for a client? Yeah. So our firm philosophy with our clients, our projections are based off of 5% per year. So obviously lower than the 7 .2% that we just mentioned, but higher than the average general inflation of two to 3%.

So just like you said, if these costs continue, it’s not gonna be sustainable for the average American family to send their kids to school. So something’s gonna have to give. Yeah. And then a lot of the discussions I will have is, so when we’re thinking about planning for college, a public school will generally say is like 25 ,000 issues.

a year, different in -state tuition could be less, could be more, let’s say roughly $25 ,000 a year. A private school could be upwards of $7 ,500 ,000 depending on where you’re going. That’s a very good, I’ll help clients understand, let’s get a clear understanding.

Do you want to plan for a public school or a high -end private school? That’s a huge difference in cost. Or do you want to plan somewhere in the middle at $50 ,000 a year, which would be cover a public school, obviously would cover some private schools, but not all of.

Let’s talk about what is, let’s just say we’re going to meet in that middle ground, $50 ,000 a year somewhere in between. What could somebody that has a one -year -old, 18 years from now, what can they expect the cost of college to actually be?

Yeah, so in year one, if we just pull out the financial calculator, that $50 ,000 today, 18 years from now would be about $120 ,000. Oh, wow. Almost triple over double. Right, in 18 years from now. like you said, between public and private.

If we look at a school that instead is 30 ,000, instead of 50, that future value is 72. So it’s gonna be a huge, it’s gonna make a big difference, you know, what we’re basing these plans off of, for sure.

So 120 times four, so roughly almost half a million dollars they would need just to cover four years of undergrad. So I always, the first, we always make sure clients are sitting down when we show these numbers, because they can get pretty big in the future, especially many of our clients have multiple kids.

And so it’s important that we get started early and plan appropriately. So again, so okay, so half a million for undergrad, just in between public, private, and then a post grad could be another half a million.

So you could need a million dollars per kid, you have three kids, it could be anywhere between one and a half to three million dollars, which is huge numbers. I think that just highlights the importance of starting this early on.

I’m gonna do a quick simple, or a quick compound interest calculator. 18 years, what you would need to save to have a million dollars or to have half a million dollars. Okay, so a little under, a little over $1 ,000 a month growing at 7% per year.

$1 ,000 a month to get you about 450. So that’s basically, if you’re starting with a newborn and you wanna plan for a middle ground public, private school, 50 ,000 a year, you’d need about, you know, $1 ,000 or $1 ,200 a month.

And we’ll talk about how to allocate that, but that’s a good, just a good estimate of, again, could be less for public school, could be more for private school. But starting early, obviously, if you started 10 years later when the kid’s 10 years old, that number’s probably gonna be double, if not triple.

Okay, let’s talk, we’ll talk about where to actually allocate that money and the different types of accounts in our philosophy, but let’s talk, this is really important, I get a lot of questions around this.

Chris talked to us about the FAFSA, how that works, is parents in, is it on parents’ income? Does it matter if there’s assets in the children’s name, which is take a dive? Yeah, absolutely. So, the FAFSA stands for Free Application for Federal Student Aid.

This is a form that’s filled out online, FAFSA .gov. So, this determines what the family’s expected family contribution is going to be and also determines how much aid the government is going to provide in the form of loans, grants, et cetera.

So, things that you just mentioned, assets in the parent’s name are considered as well as the child’s name, which we’ll get into a little bit more. And then other factors include income, household size, number of kids in college.

So, if you have more than one kid in school at the same time, which against the case for many families, that’s also considered, which helps. And then also tax filing status, age of parents, marital status.

There’s a bunch of factors that go into this that determine how much do you have to put up and how much is the government going to help in the form of aid, loans, and grants. Okay, so important to note, if you’re a high income earning family, it’s not going to matter, but retirement accounts, retirement assets do not count towards the FAFSA, meaning that if you had, if you’re a family and you had all your money in retirement accounts and your income was lower on an annual basis, it’s not going to impact the amount of money that the child’s getting on their FAFSA from the government in grants or loans.

And then on the flip side, 529 plans do count. So if they’re in the parent’s name, it’s the asset of the parent. If it’s in the child’s name, obviously any type of account is the asset of the child. So it can have an impact on the FAFSA account.

So that’s going to impact our philosophy on how we want to save into different types of accounts, but anything else to add on the FAFSA? Yeah, so parental versus student assets is extremely important.

So the way this works is it’s a percentage on… So a quick example would be for parental assets. It’s 5 .64% is the metric that’s used. So the example would be for every $10 ,000 that’s in a parent’s name, approximately $564 would be added to the family’s expected contribution.

So that’s where that 5 .64% comes in, if that makes sense. Compared to a student assets, that’s 20%. So if a parent has $10 ,000 in their name, the family has to put an extra 564 in. But if the student has 10 ,000 in their name, they have to put an extra 2 ,000 in.

So that 20% versus 5 .64 could make a huge difference on how much the family has to put in. Another note on the 529s, a lot of our clients, we do try to do generational planning for a lot of our clients, and grandparents will have these accounts set up for the benefit of the student.

Could be aunts, uncles, anybody, grandparents, close family, friends. If the 529 is again in the parents name, it’s a parental asset. If it’s in the child’s name, it’s a child asset. But if it’s It’s in somebody else’s name, like the grandparent, it doesn’t count towards any of that and is not counted towards the FAFSA at all.

So that could be a big benefit and something to keep in mind. Okay, so that’s a good segue into the different types of accounts we’re gonna go through here. First one, probably the most common is 529 plans.

So 529s are state specific, they’re state run accounts. So it’s important to know, depending on the state you live in, the tax benefits, what plans you do or don’t have options to fund. But Chris, talk about the, let’s use Pennsylvania for example.

Again, some states have zero tax deduction. What’s the Pennsylvania state tax deduction, 529 plans? Yeah, so for state tax, you can save, and PA, our state tax is 3 .07%. So say a family, husband and wife, maxes out a 529 plan.

They could technically, they could do 34 ,000 up to the, I say max out up to the gift limits. So that- 17 ,000. per child, per spouse. Correct, yeah. So, let’s just assume married couple has one kid, they’re each eligible to do 17 and 17 without impacting their any gift tax considerations.

So that 34 ,000 would be a deduction for PA state tax. So you’d save 3 .07% on the 34, which works out to about $1 ,043 in tax savings. Okay. And you can also do a five -year accelerated gift. So multiply that times five, so 85 ,000 per spouse, 170 ,000 in one year, and then you can’t contribute for five years.

Obviously, you could take the deduction in that one year. Some states cap the deduction, some, right? So again, very important to understand your state rules for this. But a couple other things to note with 529 plan.

So once the money goes in, you get a small state tax deduction, no federal tax deduction. It’s invested, grows tax -free, all the accumulation, or tax deferred, I should say. Accumulations tax deferred, if it comes out for a qualifying education expense, you don’t pay any taxes.

You can, why a lot of people like these, like you said, generationally, you can change beneficiaries to other children, or you can keep it and have it for future grandchildren. You can go to any family member, you don’t pay any taxes on it, just stays in the 529.

And let’s talk about if it’s not used for college. Let’s say you have, you know, you’ve put 250 into a 529 account, 250 ,000, it’s grown to 500 ,000. Kid doesn’t go to school. What happens? Yeah. So unfortunately, be a tax impenalized on just the growth portion, which is good news.

You always get your money back tax and penalty free. But say, you know, you put 100 ,000 in, the account’s grown to 150, and we take that full 150 out. That 50 ,000 of growth would be subject to a 10% penalty and ordinary income tax.

So depending on if you’re in the 24, 32, 37% bracket, that could be potentially a big loss. on any growth. So, in your example, you’ve put 100 in, your 100 come out tax -free. Let’s say there’s 50 ,000 of growth.

If you’re in the highest marginal tax bracket, 37% federally, plus a 10% penalty. So almost 50% of the growth is going to taxes. So of that 50 ,000, 23 ,500 is going to government and then you would get back half of that 50 ,000 basically plus the 100 ,000.

And then what if, so if the kid gets a scholarship? You can pull out your, what you put in that 100 ,000 again tax -free. You can avoid that penalty, the 10% penalty. This is actually a mis, I feel like a misconception that people don’t fully understand that if the kid gets a scholarship, there is a way out of the 529, but you still pay taxes just like you pay income on the growth.

You avoid the penalty, can still get the money out, you save 10% basically. And then what’s another way with the Secure Act that was just passed? Pretty relevant for excess money in a 529 plan, but what’s the new?

Yeah, so there’s a big big change with these plans. Usually they’re kind of restrictive. They’re not very flexible if you don’t have those college costs like we just went through with the taxes and penalties.

But now there’s a new provision that allows you to roll the balance up to $35 ,000 as long as the account has been in existence for 15 years, 35 ,000 of that 529 plan can go into a Roth IRA for the benefit of the beneficiary.

Okay, so if you’ve over accumulated, you get $35 ,000 out into a Roth IRA, which could be pretty impactful. I do believe that starts in 2024, so that could start next year if the accounts have been open for 15 years.

So, hello, every 529 plans are great. They are also asset protected, which you didn’t mention. So, if the parent gets sued, they’re protected. And again, state by state, Pacific, make sure you consult from a legal standpoint of your state laws.

But basically, high level of review, they’re good for tax -free accumulation, come out tax -free if used for qualifying education expenses. We don’t want to over accumulate because you get hit with a penalty and pay some taxes on the growth, but also can be transferred beneficiaries pretty easily to any of their family member.

Just to stress to make sure you’re up to speed on your state specific laws. But other than that, these are the best accounts that we can put money in for college planning as long as we know that it’s going to be used for those qualified expenses, which can include tuition, room and board, books, quite expansive that you can use it on.

Okay, well, let’s give, so again, that’s the most common. Let’s just give a high level review. So, Coverdales, they’re not really very popular, but what’s, give us high level review. Yeah, so these, I believe, have mostly been phased out since 529 plans have came along, but…

Unlike the 529s, these do allow for a federal tax deduction, but the contribution limit compared to 529s and big picture of your tax situation. It’s only 2 ,000 per year that can be deducted against federal taxes.

And there’s also a MAGI, so you’re Modified Adjusted Gross Income. If you’re single and your MAGI is over 95 ,000, or if you’re married and it’s over 190 ,000, you’re not eligible to contribute to these.

But from a tax standpoint, you get the $2 ,000 deduction, the funds grow tax -free, and just like the 529, if you use it for an education expense, the funds can come out tax -free as well. So these aren’t as popular in your works as income limits and 529s are just a little bit more flexible.

Yeah. could accumulate money in the taxable investment accounts. You’re paying capital gains taxes on the growth. You avoid some of the tax savings of 529 plan. But if it’s not used for college, this can be a good option because you’re only paying capital gains rates versus so let’s assume highest tax bracket, 47% of the growth is going to taxes and a penalty in the 529 if it’s not used.

Whereas the taxable account highest marginal tax rate, highest capital gains rate if you’re in the highest marginal tax rate, the highest marginal tax bracket is 23 .8%. So if it’s not used for college, a little bit of savings versus the taxes and the penalty.

And this could be important for high income earners because you can send money directly to a school for tuition for somebody else and it doesn’t count as a gifting. It’s not, it doesn’t count as that gifting limit each year.

So it may make sense to either cash flow college for a high income earner sometimes or pay out of a taxable account because you’re gonna get money out of your name and still gift the full 17 ,000 to that same person.

And then let’s talk about, so UTMA is an UGMA accounts, give us a high level review of those. Yeah, so also not, so these were also kind of, they were popular years ago, but since again, better options with the 529s, we don’t see these that often.

Primary use for these is to gift funds to the next generation generally. So UTMA stands for Uniform Trust for Minors. It’s an asset for the parent until the child reaches what’s called the age of majority.

That could be 18 to 21, depending on what state you’re in. However, the downside of using these for college, like we said earlier, child assets hurt you for the FAFSA and these UTMAs and UGMAs go into the child’s name, say for at age 18.

If there’s $100 ,000 in that account, that could go into the kid’s name and then your financial aid is impacted. But from a tax standpoint, it’s treated just like a regular investment account. There’s no big tax benefits like a 529.

So we generally do not recommend these to our clients, but it’s something that comes up if you Google, you know, what types of accounts can I use for college? This, this along with the coverdells are probably going to come up.

So we wanted to at least spend a second explaining, you know, what these are. And I’d say again, big reason we don’t recommend these is because when, depending on the state, 18 or 21, the kid can use the money for whatever they want.

Right. So I don’t know about you, but when I was 18, if I had a lot of money in a account that I could use for whatever I want, probably wouldn’t be yet. The account probably wouldn’t exist today. So not the best.

Obviously, again, depends on a lot of factors there, but generally it just you just lose some control over those. And then the last one I want to hit on is a Roth IRA. This is important for lower income families.

We would recommend. Funding a Roth IRA first over 529 plans and reason being so if you if you’re doing a backdoor Roth IRA or a Roth conversion You have to wait five years to access any of that money You can always pull your basis out of what you’ve put in before age 59 and a half again Roth conversion or backdoor Roth You wait five years if you’re doing it just a direct Roth IRA contribution you can pull that basis out at any time So for lower -income families may make sense fund Roth IRAs first And then you could always pull the basis out for college if you did it so Still would recommend 529s, but if you were to choose one or the other We would say put the money in the Roth because gross tax -free a little bit more flexible versus the taxes in the pound.

Yeah Okay, and then Yeah, let’s just talk about I think the only thing left is our general philosophy is a firm EWA So Chris if we just use the example from the beginning we need a million bucks for college For one child, let’s say we’re gonna go to pick a High -end private school for four years.

What’s our philosophy? How do we recommend? Allocating money. Yeah, so like we just talked about the 529s can you can be penalized and in taxed pretty pretty Substantially with the 10 and that if you’re in the high -income bracket almost half your growth can go away so we generally recommend especially while the kids are young and Goals are uncertain.

We we recommend to do a 50 -50 split of funding the 529 and Funding the taxable account and that just allows us to have flexibility So we get the tax benefits on the 529 side and then we get the flexibility on the taxable account because it can be used for anything So that way we’re not over accumulating in an environment where we could potentially get taxed and penalized pretty heavily Yeah, so having a good split gives you some tax benefits plus flexibility and this depends too on philosophies We have some clients that want to overfund 529s You know, they just think hey, we’ll give it to family member if they don’t need it.

We have other clients that hate 529s. I don’t want it being locked out for college. I’d rather just pay the capital gains taxes and have the flexibility for it. Some of that depends on philosophy and then also depending on now with the Secure Act, 35 ,000 could come out.

That could impact maybe put a little bit more in the 529s. Different legislation changes. If tax laws change, that could shift. But general philosophy now and then talking from an investment standpoint, why we like this mix.

If the kid’s 17 years old, we’re going to obviously want to hold some of this money in as they approach 18 or whenever they’re going to need the money, we’re going to put some of the investments in some stuff that’s more conservative.

For example, if we’re going to hold some bonds knowing that the money is going to be available for college, we would choose to do that in the 529 plan because a couple of reasons. Number one, there’s a tax deferral versus if you hold bonds in a taxable account.

pay taxes on it, any interest or dividends in the bonds in the 529 plan, you don’t pay taxes because it’s a tax deferred account. So we can hold bonds in there for tax efficiency. And that’s going to be the money that we’re going to draw on first because, again, has to be used for qualifying education expenses to get the tax benefit.

And so if the market’s down when the kids in college, we can just draw on that money that’s in bonds. And then let’s say they run out of that the first two years, and there’s money in a taxable investment account, we have the other half for the second two years.

That account, we would leave in 100% equities growth oriented so that we can be tax efficient in that account because it’s taxable. And then if the market’s down, you could always take out student loans, pay for the last two years of college.

And then once the market recovers, use the taxable account to pay off the student loans, you cannot use a 529 plan to pay off student loans. So we like this mix because it gives us a lot of different ways that we can be flexible from a tax standpoint and from a distribution standpoint.

So again, specific on philosophy, cost of college, what the client wants to fund and their goals, but that’s the general philosophy is a 50% split between taxable account and a 529. Yeah. And one other thing to add on that, if you have, because a lot of times we’re trying to shoot moving targets on this with the biggest one being what’s your kid going to even want to do 18 years from now because we don’t even know what college the environment’s going to look like at that time, let alone where they’re going to go, what they’re going to study, etc.

So this allows us to use the 529, get the tax benefits. But if we have a healthy balance and a taxable account, say the kid gets into junior year, senior year of high school, and we’re starting to tour colleges, and we actually have an idea of what to expect, we can always move money from the taxable account over to the 529.

So I know we’ve done this for a lot of clients that have kids at that age where we’re just filtering the money through the 529 almost just. just to get the tax deduction and then we’re sending a check directly from the 529 to pay the tuition.

So, having that mix just gives you the ultimate flexibility whenever we’re trying to plan for some goals that are kind of uncertain many years down the road from now. Yeah. Well, that’s, yeah. Thanks for sharing.

Anything else to add? I think that’s a pretty good general overview of college or anything that we missed. I don’t think so. That should just about cover it. So, yeah, important to have a general philosophy and plan around college.

Again, sometimes this can be the most important goal for clients, even more than financial independence. We always like to use the term, you can take a loan out for everything except for retirement. You can take a loan out for college, you can’t take a loan out for your retirement.

So, we definitely recommend having some sort of plan to be financially independent at some point as you can’t take the loan out versus you could for college. But if you have any questions about your specific planning, feel free to reach out and we would appreciate five star like on this podcast and any feedback is welcome.

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