One of the things that makes Delegate such a special place to work is how much the employees care about each other. We are not just co-workers who see each other inside the office (or virtual office – thanks COVID). We are involved with each other on a holistic level, and with that, we are pleased to announce the newest member of our Delegate family. James Thomas Revelle was born on November 11th in Durham, North Carolina. James is the son of Thomas, one of our associates, and his wife Rachael. They also have a four-year old son, Judah, and they are embracing every moment of their new life as a family of four.
As someone that thinks about financial planning and models all the time at Delegate, Thomas already has a plan in place for funding James and Judah’s college education. We frequently discuss education funding for children, grandchildren, and extended family with our clients, so we thought this was the perfect opportunity to summarize some of our thoughts.
The main strategies we see deployed are Qualified Tuition Programs (QTPs – often referred to as “section 529 plans”), custodial accounts, children’s trusts, and direct funding of education expenses. Each option has advantages and constraints to consider, and the best solution is often dependent on the unique circumstances of each individual family.
Qualified Tuition Program (QTP) or 529 Plan
- Programs established and maintained by individual states or educational institutions that allow you to either prepay or contribute to an account that will be used to pay for qualified education expenses at an eligible educational institution
- Contributions
- Not tax deductible
- No income restrictions on the individual contributors
- Gift tax implications
- Contributions up to the annual exclusion amount ($15,000) can be made by anyone without tax implications to the donor or recipient.
- There is a provision for making an accelerated contribution of up to 5 times the annual exclusion amount at one time and treating the contribution as if it is made over 5 years (if this is done, additional tax-free contributions cannot be made for 5 years
- Growth inside the plan is not taxed
- Distributions
- Do not have to be included in income if used for qualified educational expenses
- Not taxable if used for qualified educational expenses
- If not used for qualified educational expenses, then distribution is included in the beneficiary’s gross income plus a 10% penalty tax
- Qualified educational expenses – expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution
- Higher education expenses include tuition, fees, books, supplies, equipment, room and board (must be enrolled at least half-time), computers, books, and up to $10,000 paid as principal or interest on qualified student loans
- Elementary and secondary education expenses are for no more than $10,000 of tuition at eligible elementary or secondary institution
- Designated beneficiary – generally student (or future student) who will receive the benefits
- Can only be one person
- Can be changed (useful if there is an additional child and there are additional funds in the plan after the original beneficiary completes education)
- Assets can be rolled over or transferred from one QTP to another QTP
- Assets in a 529 plan are not included in the parent’s estate
- A deeper dive into 529 plans can be found in Appendix A, below
Source: https://www.irs.gov/pub/irs-pdf/p970.pdf
Custodial Accounts
- Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts allow parents to put cash and securities into custodial accounts for a child
- Parent can be custodian, but child is considered the owner, so assets in the account will be part of financial aid calculations
- Allow income to be shifted to minors and saved for funding educational expenses
- Virtually no administrative costs
- Major drawback: when the child reaches age of majority (18 or 21 depending on state law), the child can gain access to funds in the account and use however they want
- Each account can only be assigned to one child and can’t be transferred (so funds could not be used for siblings’ educational expenses)
Children’s Trusts
- Funding trusts for the benefit of children is an alternative to 529 Plans and custodial accounts. Proceeds from these trusts can be used to pay for education and other expenses such as healthcare. They serve as a foundation for family estate tax planning and require careful analysis and consideration…more than we can provide in this article.
Direct Funding of Education Expenses
Direct payment of tuition is an excellent way for individuals to increase their annual support for extended family. So long as tuition is paid directly to the school or college, it does not count as part of the annual limit on gifts which is currently $15,000 per person with no limit on the number of individuals to whom you can make gifts. Please see our separate article on annual family giving.
Appendix A
We have modeled the use of a 529 plan to pay for college expenses for a child. This model helps guide decisions about how much funding is required and when to make the contributions. The 4×4 sensitivity table below shows the ending portfolio balance after the child finishes their final year of college. This output allows us to change four key variables and see 256 different outcomes based on those variables. The four key variables are:
- Cost of College (Present Day $’s): This is the current annual cost of college, and this cost grows each year at 5%.
- Investment Return: The portfolio grows tax-free. Modest return assumptions are used due to the relatively short time horizon. As the child approaches college age, you should shift the portfolio to more conservative investments.
- Initial Contribution (At Birth): The amount that is put into the 529 Plan when the child is born. The 2021 annual exclusion limit is $15,000, so the variables of $30,000, $60,000, and $90,000 allow for tax free funding by two parents, two parents plus two grandparents, or two parents and four grandparents, respectively. Donors to a 529 Plan may contribute up to 5 years of annual gifts in the first year, but must wait 5 years before they can make additional contributions. (For this example, we assume gifts are made annually.)
- Annual Contribution: This is the amount of funds contributed to the 529 Plan each year. The amount shown is the current value, and the model grows this amount with inflation. No annual contribution is made in the first year since the initial contribution happens in the first year. Annual contribution starts at the beginning of the second year.
We have a blue box around $22,767 near the middle of the table. This is the value of the 529 Plan when the child finishes college assuming the child attends a college with a current cost of $70,000 per year, the portfolio generates a 5% after-tax return on an initial contribution of $30,000, and annual contributions of $15,000 (grow with inflation). In this scenario, the cumulative investment returns (from birth through college graduation at age 21) are $275,813. Due to the tax-exempt nature of the 529 Plan, none of this growth is taxed. If you apply a 20% long-term capital gain tax to this amount (which would be required if the growth was outside the 529 Plan), the tax bill would be $55,162.
There is a large range of outcomes shown in the output table. Negative numbers mean the 529 Plan did not have sufficient funds to pay for all the college expenses, and positive numbers mean there were excess funds. In a planning discussion, a table like this would be our starting point, but we would then narrow the ranges based on specific family circumstances. Annual funding would be re-evaluated on a regular basis with the goal of having the portfolio balance at the end of college be zero.
Conclusion
The tax benefits of funding a 529 Plan are significant. Regardless of the amount contributed on an annual basis, it’s good to begin saving early for college as the compound returns over time can make college much more affordable.
Disclaimer
This material is for information purposes only and for the use of the recipient. Under no circumstances is it to be considered an offer to sell, or a solicitation to buy any investment referred to in this document. Although we believe our sources to be reliable and accurate, we assume no responsibility for the accuracy of such third‐party data and the impact, financial or otherwise, it may have upon any client’s conclusions. Delegate Advisors, LLC has not audited or otherwise verified this information and accepts no liability for loss arising from the use of this material. The information contained in this document is current as of the date indicated. Delegate Advisors, LLC undertakes no obligation to update such information as of a more recent date. Any opinions expressed are our current opinions only. Nothing herein should be construed as investment, legal, tax or ERISA advice. You should consult with your independent lawyer, accountant or other advisors as to investment, legal, tax, ERISA and related matters to which it may be subject under the laws of the country of residence or domicile concerning the acquisition, holding or disposition of any investment in the account. Past performance is not indicative of future results. All investments involve risk including the loss of principal. Any investments discussed within this material may be subject to various fees and expenses, which will have a negative impact on performance.