Another article about college. If you pay any mind to financial news, or simply have kids or grandkids, you’re likely sick and tired of the conversation. Unprecedented student loan debt. Obscene tuition rates. You need a degree to get ahead nowadays. Guidance Counselors. Overpriced books. Mandatory meal plans. Join clubs and get volunteer hours. Homesickness. FAFSA, FAFSA, FAFSA!
Rather than pile on to all the concerns around the multi-trillion-dollar business known as higher education, we’re going to look at what happens when your child decides to go in another direction. That’s right, not every kid goes to college. So, then what happens to all those years of college planning and savings?
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What to Do With 529 Savings Plan Funds
Arguably the most marketed solution for college planning is the 529 savings plan. These are investment plans operated by states or educational institutions with potential tax advantages and incentives for the education of a designated beneficiary, such as a child or grandchild.
First key point: Notice I said education and not just college. The 2017 Tax Cuts and Jobs Act under President Trump allows people to use 529 plan funds for K–12 tuition expenses as well as college.
But what if you saved all those years your children went to public school and then they take a pass on college? You can change the beneficiary to another member of the family without any penalty.
Or what if there are no younger siblings, college was cheaper than expected, and there’s no longer a need for college funding?
The 529 owner can withdraw funds at any time for any reason. If, however, the funds are not for a qualified education expense, the money will be subject to income tax and a 10 percent penalty. The plan’s basis would be returned tax and penalty-free.
Exceptions to the 529 Plan Withdrawal Rule
However, every rule has its exceptions. Penalty-free withdrawals can be made in the event of a beneficiary’s death or disability, or if the beneficiary receives a tax-free scholarship, receives education assistance through an employer, attends the U.S. Military Academy, or has qualified education expenses that generate American Opportunity Tax Credit (AOTC) or Lifetime Learning Tax Credit (LLTC). That said, any plan earnings would still be taxable.
The less popular Coverdell Education Savings Account has some similar consequences for unused funds (i.e., gains are subject to income tax and a 10 percent penalty). However, unused funds go to the beneficiary, so the parent cannot just pull back the funds as in a 529. The Coverdell has a slightly broader definition of qualified educational expense by referencing K–12 “expenses” as opposed to 529’s K–12 “tuition.”
One of the most notable distribution drawbacks is that the beneficiary must make all withdrawals by age 30. Coverdell owners are now able to convert to a 529 if they so choose.
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Other College Savings Plans
What about those old custodial accounts, like UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act)? These accounts involve an irrevocable transfer of assets from parent to minor, potentially taking advantage of the child’s lower tax rate. Once the child reaches age of majority, they own the assets and can use them without restriction, whether for college or any other use.
Roth IRAs and Other Investments
How about the Roth IRA? Wait, is that a retirement plan? This vehicle funded by post-tax contributions can offer up a tax-free source of income in retirement (so long as the owner is over age 59.5 and the account has been funded for more than five years).
What’s the connection to college planning, you ask? Contributions to a Roth IRA are available tax and penalty-free at any time.
In other words, the investor can withdraw his or her basis to pay for college and let the balance continue growing for retirement. Furthermore, there are exceptions to waive the 10 percent early withdrawal penalty on said earnings, one of which is for higher education of the plan owner or their immediate family members.
Finally, the classic nonqualified brokerage or investment account (i.e., stocks or mutual funds held in your name). These assets can be used for any purpose just like a savings account, the only drawback being the potential for interest, dividend, short-term, and/or capital gains taxes.
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We’ve yet to mention one asset that typically falls outside this marketable security category and is rarely thought of in college planning, but is actually used for this purpose very often. That is home equity. Many Americans find their home to be one of their biggest assets, and the ability to downsize, take a second mortgage, cash-out refinance, or tap a Home Equity Line of Credit (HELOC) can all offer much needed cash for higher education. What if your boy or girl skips out on college? Then you keep on living in your home without a hitch.
The Bottom Line on College Savings Plans
That about covers the most recognized sources of college funding, not counting the over trillion dollars of student loans and the consequences of not using those plans as originally designed. All investment decisions should come with careful thought and coordination with your advisers, and with a Plan B.