Financial Planning 101: Part 6
Educational Funding — A Layer Cake Approach
by Gerald Townsend, Financial Editor
June 2009
In its most recent update of costs, the College Board reported that the cost for in-state students at public colleges were about $18,000, an increase of over 5% from the previous year, while out-of-state students faced a higher cost of over $29,000 per year. Not surprisingly, the cost for private colleges was even higher, at over $37,000 per year.
If you are the parent (or grandparent) of a young child, what’s the best way of getting prepared for these costs?
Of course, you could just deal with it when the time comes. With this approach, you plan on covering these staggering costs by using some combination of the parent’s future earnings, the student’s part-time employment, scholarships, loans or other financial aid. For those who don’t start planning early enough or have the ability or discipline to stick with a savings program, this becomes their default and only option.
However, for parents who start a consistent savings plan early enough, there are better options. In this article, we’re going to examine how to bake a three-tier educational layer cake.
UTMA — The First Layer
A Uniform Transfer to Minor’s Account (UTMA) is an account that names one of the parent’s as the custodian for a minor child. Any investment earnings generated within the account is taxed to the child, which should be a good thing because the child will presumably be in a much lower tax bracket than the parent. However, because the imposition of the " kiddie-tax " may result in a child’s unearned (interest and dividend) income being taxed at their parent’s higher tax rate instead of the child’s lower tax rate, UTMA’s are not as attractive as they used to be. Nevertheless, I think they can still play an important role in a child’s savings plan. Here’s why: The first $950 (for 2009) in unearned income a child receives is not subject to any federal tax and the second $950 is taxed at the child’s tax rate (which starts at 10%). Therefore the total federal tax paid on the first $1,900 in unearned income is just 5% — a very low tax rate. Unearned income above this $1,900 threshold is taxed at the parent’s tax rate, which makes it unattractive to generate more than $1,900 per year. However, keep in mind that this $1,900 amount is indexed, so it increases each year. If a child had $30,000 in a UTMA that earned 5% per year, it would only generate $1,500 of income and incur a federal tax (based on 2009 rates) of $55 — not bad. Keep in mind that we are just discussing federal taxes, and you also need to consider the impact of state income taxes.
The big advantage of the UTMA is that, unlike the next two layers of the cake, the money in the UTMA is not restricted to just being used for educational costs. It can be used for any "non-support"item. Therefore, it is much more flexible.
ESA — The Second Layer
Once the balance of the UTMA has reached a level to begin making the annual income subject to the kiddie-tax, it is time to start funding the second layer — an Educational Savings Account (ESA). You can only put $2,000 per year in these accounts and if the parent’s income is too high you aren’t even allowed to contribute, but if you can contribute, you should. They have two big advantages over the third layer. While the money can only be used for educational costs, the definition of "educational cost" is broader and they are not restricted just to college costs but are available for elementary and secondary school as well. Finally, your investment options are practically unlimited with ESAs. Your investment earnings are not taxed, either while they are accumulating or when you distribute them, as long as they are used for qualifying educational expenses.
529 Plans — The Third Layer
Once the first two layers are funded to their maximum, we’ll add the final layer, a Qualified Tuition Program, which is also known as a "529 Plan". Similar to an ESA, the investment earnings are not taxed during accumulation or distribution, if they are used for qualified educational expenses. Unlike an ESA, your ability to contribute to these plans is not affected by your income and the limitation on how much you can contribute is very high. However, they have much less investment choice and flexibility than an UTMA or ESA, a more narrow definition of "qualified educational expense" and can only be used for post-secondary (college) costs.
So, that’s the approach — fund the UTMA up to a reasonable level and then add an ESA and a 529, if needed. Finally, bake it for a sufficient number of years!
Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com