How To Reduce Your College Savings Risk

Forbes - March 4, 2021


I have relatives that diligently contributed to their 401(k) over the years, putting in more than their employer match to save as much as possible. In fact, almost all of their savings went into their employer-sponsored retirement plans. Fast forward to their retirement and they’re paying more in taxes today than they did in their working years.

They might have been able to increase their overall return and reduce their taxes by diversifying the location of their investments. Asset Location Improves Risk-Adjusted Returns

In investment terms “diversification” typically refers to a mix of asset classes such as stocks, bonds, and cash to reduce risk and increase potential returns. For example, fixed income may be more resilient when stocks decline or vice versa. But diversification is about more than just asset class , it’s also about asset location , which can mitigate risks and improve returns where class diversification alone cannot.

Stocks and bonds are the assets we purchase and whose value changes over time, but asset location is the place we hold them. For example, if you want to buy a mutual fund you can do so through the fund provider, inside your 401(k), a brokerage account, a Coverdell account- the list goes on and on. Each account offers different benefits. These accounts have varying degrees of tax benefits associated with them. To that end, asset location diversification reduces legislative risk and tax risk.

Consider that the 401(k) has only been around since 1978 and the Roth IRA since 1997. Section 529 of the tax code, which created qualified tuition plans like 529 savings and prepaid programs, was added in 1996. The 529 has been improved many, many times over the years in tax codes updates in 1997, 2001, 2008, and many times since. Tax laws change often, making some investment vehicles more desirable from a tax standpoint, and other less.

The UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) were once a staple of any wealth transfer strategy due to tax benefits associated with the minor. Changes in 2008 tax law made these accounts far less desirable, resulting in many UGMA/UTMA accounts rolling into 529 plans.

There is no predicting the future as tax rates and account treatments change. To reduce this risk and potentially improve after-tax returns it is important to diversify asset location, putting savings into different account types.

Consider your retirement savings; if you rely exclusively on your traditional 401(k) you’re deferring your taxes. When you retire and start making withdrawals the distributions are taxed. The idea is that you get greater tax savings and compound growth during your working years and pay less in taxes while your retire and are in a lower tax bracket. But what happens if you end up in a higher tax bracket, or if tax rates increase after you retire? What happens if you need access to those funds during your working years? According to Bankrate, nearly one in four Americans have drawn on their retirement account since the onset of Coronavirus. Considerations For College Where to invest your assets depends greatly upon your personal financial situation. Different college savings vehicles offer varying tax and financial aid benefits, meaning the location you select may have a direct impact on your overall return. Consider carefully financial aid eligibility, risk tolerance, investment knowledge, state of residence, desired school and program, and time horizon, among other factors unique to you. Also note that a combination of vehicles may make the most sense, particularly where there are children with a large age disparity.

College Asset Locations Following are some of the most common places Americans invest and save for college and a brief summary of some, but not necessarily all, of their asset location benefits. Assets with a “(x)” next to them may have preferred financial aid treatment, as well.

  • (x) 529 Plans (Prepaid or Savings) – 529 plans have a lot going for them, but the primary benefit is the accounts are federal and state tax-deferred, and tax-free if used for higher education expenses. Investors with longer time horizons and in higher tax benefits get the greatest benefit, though depending on the state and income bracket of the saver there could be additional benefits such as matching grant programs and state tax incentives only available to lower income brackets. Some states also exclude savings in the in-state 529 plan from consideration when calculating financial aid at in-state schools. Most plans only allow one account owner, even if a couple is married, so consider carefully any ownership factors when looking at an account, particularly in the case of children from a prior marriage or a pending divorce.

  • Bank Accounts (Checking, Savings, and CDs) – Assets held in cash inside a bank account are subject to eroding factors such as inflation plus the opportunity cost of alternatives had that money been invested. Certificates of Deposit can offer investors seeking assurance of principal a low-risk option. Depending on your time horizon and deposit amount you can match the CD to the dates of attendance and/or “ladder” a portfolio of CDs to mitigate interest rate risk. You sacrifice some versatility by locking up the assets to gain a slightly better return versus a savings or money market account.

  • (x) Coverdell ESAs – Coverdells share many of the benefits of 529 plans, but with access to a wider selection of investments. There is an annual contribution limit of $2,000 per beneficiary, though. Plus, you cannot contribute if your income exceeds certain thresholds, and they do not benefit from many of the state incentives of 529 plans such as state tax deductions and other perks.

  • (x) Education Savings Bonds - Series EE or Series I savings bonds may be redeemed tax-free for use for qualified higher education expenses under certain circumstances. However, according to the U.S. Department of the Treasury, “a bond bought by a parent and issued in the name of his or her child under age 24 does not qualify for the exclusion by the parent or the child,” making it difficult to qualify. In combination with the low interest rates offered by these bonds and long time horizon, typically 20 years, they are rarely used for college expenses.

  • Prepayment – Different from a 529 prepaid plan, some schools allow you to prepay tuition directly with the institution. This can reduce the total cost of attendance by paying the full attendance fee up-front, though you lose some versatility by doing so. Typically students must already be enrolled at least half- if not full-time to prepay tuition. The benefit here is for large gifts, since direct payments to the school are excluded from gift tax consideration, and locking in tuition at the first year rate. For adults shifting wealth to their grandchildren, prepayment may offer a tax-efficient method of transferring those assets. Be sure to speak with the institution and a tax professional .

  • (x) Roth IRA – The benefit of a Roth IRA is that if the assets are not used for college they can be used for retirement. However, you can be disqualified from contributing if you earn too much or have no earned income. Further, you can only withdraw the principal for college expenses without tax consequences. While assets in a Roth are excluded from federal aid consideration, withdrawals will count as income to the beneficiary in the tax year of the withdrawal, potentially decreasing future aid eligibility. Ideally, the family is already maximizing their Roth IRA contributions and is able to use a dedicated college savings account.

  • Taxable Accounts – A traditional brokerage account with no tax-deferred status is sometimes the best solution for college savers, particularly if the child is closer to the age of attendance or they live in a state without in-state benefits associated with their 529 plan. Taxable accounts offer the widest range of investment options and most flexibility in terms of use.

  • UGMA/UTMA – Assets held in these accounts have limited tax benefits that are somewhat complex. The real benefit is that assets in these accounts must be used for the benefit of the beneficiary, which can be significant depending on the circumstances of the family. For example, the account owner of a 529 plan can change the beneficiary or revoke the gift entirely, and usually only one owner is allowed. Using a UGMA/UTMA title on a 529 account ensures the assets are used for the benefit of the intended party.

Brian M. Boswell, CFP ® is a registered representative of and offers securities through MML Investors Services, LLC. Member SIPC. www.sipc.org, 101 Federal St, Suite 800, Boston, MA 02110. Tel: 617-439-4389. CRN202303-279138

By Brian Boswell, CFP®, Contributor


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