While recent high school grads eagerly await their first year of college, their parents are doing the grunt work of orchestrating tuition payments to a college’s registrar or bursar’s office. Between July and early September, colleges and universities bill parents for the fall semester and then repeat the process for the spring semester if parents opted to not pay for the full year.
Some financial advisors who offer college financial planning services blog about or send out e-mail newsletters that highlight the nuances of paying for college expenses from their college savings accounts. But for those who are still new to offering services for college financial planning, this can serve as a small guide to the withdrawal process.
In the past 20 or so years, parents have had more than a few ways to save for and then pay for college. The 529 college savings account is the latest trend, but some families aren’t convinced it’s the most suitable option for their needs. So they might have sought out alternative methods like individual retirement accounts and Uniform Gifts To Minors Act (UGMA) accounts to prepare for incoming educational expenses.
Regardless of what vehicle or vehicles were chosen, Jim DiUlio, the chair of the College Savings Plans Network and director of the Wisconsin College Savings Program, says, “Anticipate and plan early” to avoid unnecessary costs.
529 College Savings Accounts: The 529 plan is edging on household name status. The College Savings Plans Network reported that there were 13.3 million such accounts in 2017 and the average account size was $24,057.
The 529 account is a tax-advantaged investment account designed specifically for families to save toward postsecondary education. Families can save in an educational savings plan, a product every state offers, or its sister vehicle, the prepaid tuition plan offered by 11 states (currently 18 states have prepaid tuition plans, but seven are not taking new applicants). One institution also offers the prepaid tuition plan (more on that later).
A 529 can be used for qualified expenses such as tuition and fees, computers and internet access (for college purposes), course-related books, on-campus room and board, off-campus rent (based on the college’s “cost of attendance” figures), and special needs equipment. While much falls under qualified expenses, the items that do not are transportation costs, health insurance and student loan repayments.
Withdrawing funds from a 529 educational account is just as tricky as withdrawing from any other long-term savings account. Families can request that the payment be sent to the account custodian, (usually a parent or grandparent), the beneficiary or a beneficiary’s parent.
When payment is sent to the custodian of the account or the beneficiary’s parent, those individuals should be aware that the IRS will treat the distribution as income and may request proof that the funds were used for qualified educational expenses.
Ronya Corey, a managing director and wealth management advisor at Merrill Lynch, Pierce, Fenner & Smith Inc., says, “It’s kind of an honor system; the only time you’re checked on that is if you’re audited.”
As funds get distributed to the parent or the school, a 1099-Q form gets sent along with them to track distributions coming out.
“[Parents] don’t have to file that with their taxes, but [they] have to keep it in case [they] get audited,” says DiUlio. “The broader picture is that we want to make sure you’re not money laundering.”
Families can also ask the provider to send payment directly to the educational institution, as long as they don’t need to use the funds for anything else.
As long as withdrawals are for qualified expenses, then families won’t pay federal taxes on them. The penalties and taxes come when families withdraw more than the total cost of college expenses for that year or take out money for nonqualified expenses.
“Withdrawals from 529 plan accounts exceeding the amount of qualified expenses paid during the tax year will trigger ordinary income tax plus a 10 percent penalty on the investment earnings portion on any withdrawal,” writes David Mayes of Bearing Point Wealth Partners on Fosters.com.
Corey points out that many of her clients who are parents pay out of pocket for a lot of things on-site and then reimburse themselves later. If this happens, DiUlio admonishes families to take the money out in the same calendar year that their expenses occurred.
Prepaid Tuition Plans
The one institution that operates a prepaid college tuition plan is the Private College 529 Plan (also known an PC529). This plan works with over 300 private colleges and universities to help families lock in a tuition price that the family can then open an account for and save toward.
Bob Cole, president of the Private College 529, believes the process for using a PC529 account to pay for school is quite simple.
After receiving an acceptance letter to a participating school, a family completes the tuition certificate redemption form. On the form, the family indicates the amount of the bill it wants to redeem with PC529 certificates if it plans on using other fund sources.
“The family may be able to claim federal tax credits, the American opportunity or Lifetime Learning [credits], if it uses funds from outside a 529 account,” Cole says.
Since families can redeem only up to half a school year’s tuition, they have to determine what percentage of the tuition they want to redeem as well. And once that is all figured out, the family sends the form to PC529, which then sends payment to the institution named on the form.
IRAs
Some families set up retirement accounts for the sole purpose of putting away money for college and other major future expenditures. Like 529s, IRAs have age-based investment options, but their expansive investment options and penalty-free early withdrawals for qualified educational expenses distinguish them from the dedicated college account.
Another difference is that federal financial aid doesn't count retirement savings accounts in the expected family contribution (EFC) estimates, though only for the first year. According to FinAid (finaid.org), the amount of money withdrawn in one year affects needs-based assistance the next year, something families should anticipate.
If a family is working with a traditional IRA, withdrawals are taxed as income since contributions to the account were tax-deductible. And withdrawals from the account must be made the same year the family plans to pay for the qualified expenses.
Families using a Roth IRA can take advantage of the tax-free withdrawals. Earnings on Roths are tax-free after the age of 59; therefore, most of a client's withdrawals will be from the principal unless they are 59.
UGMA And UTMA
The Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act can be used for anything related to the beneficiary, such as a new car or an airplane ticket from school to the young adult’s hometown, explains Corey. The downside for parents is that once the beneficiary turns of age (depending on what age between 18 and 21 the state defines), he or she is entitled to full reign over the account.
“If a child wants to go backpack through Europe instead of college, they can do that because technically the money is theirs,” Corey says.
A UGMA or UTMA is a law that gives an adult the ability to create a custodial account in a minor’s name and contribute to it without having to name a legal guardian. It’s similar to a trust because it holds and protects assets, but custodians and parents won’t be able to insert any stipulations on how they’d prefer the funds to be used once the child turns of age.
According to Corey, withdrawals from the account are the same as those for 529s—there is no penalty for distributions that benefit that young adult. She also mentions that families get a Kiddie Tax credit every year; unearned income gets taxed at the child’s tax bracket up to a certain amount, then after that the income is taxed at the parent’s bracket.
In its blog, the wealth management firm Walsh & Associates writes that the only way to avoid the unearned income getting taxed at the parent’s bracket is if the young adult (under the age of 24) earns a salary that provides more than half his or her support.
Whatever a family chooses, knowing the tax implications and the most appropriate methods to withdraw from any college savings vehicle will save those involved from experiencing unnecessary stress.