A 529 plan is a great way to invest for future education costs, but there are also other options to raise the funds you need.
Education has outgrown school. What do we mean by that? Even a generation ago, most people tended to think of schooling as finite stages of growing up. Yes, there were costs involved, but like the cuts and scrapes of childhood, they would heal and become a distant memory.
Today, we talk about education as a lifelong journey. It starts with school, but it never really ends. The associated costs have also matured and now resemble longer-term budget items, such as housing and health care. Paying for education has become a major investment—one that often requires years of careful planning. As the costs keep rising, you should approach funding educational expenses, such as tuition, extension programs and advanced professional training, like any other kind of investment that needs a strategy built for your specific needs.
One of the most challenging aspects of crafting such plans is predicting the future educational funding needs of your loved ones, or yourself. The right solution may be a mix of tried-and-true tools with innovative, lesser-known strategies to help plan for the uncertainty.
Here are seven strategies that may help cover today’s spectrum of expected, and sometimes unexpected, educational costs.
Like most long-range investment strategies, it pays to start early. Popular educational investment tools, such as 529 plans, may reward you for thinking ahead and letting your invested funds grow until you’re ready to take tax-free drawdowns to pay for qualified education expenses, including K-12 tuition (up to $10,000 annually). Many states, but not all, offer a state income tax benefit for contributions to a 529 plan. The best way to take advantage of such benefit is a good topic to take up with your tax advisor.
Here’s how impactful time can be in the growth of 529 plans: for 2020-21, costs for a four-year private college averaged $54,880 per year for tuition, fees, room and board, books and supplies, transportation, and other expenses1. Assuming a college cost inflation rate of 4%2, if you open the account when your child is born, you’ll need to contribute approximately $906 a month (over 20 years, earning an average of 7%, your total contributions would be $228,258) to have a high likelihood of being able to meet college costs when needed. If you wait until they are 12, you would need to save $2,156 a month3. Alternatively, if one were to borrow for the full amount at 6%, the monthly payments would be $3,250 for 10 years, thereby costing $396,123 more than starting to invest for the newborn for the same college costs incurred3. This is a hypothetical illustration; actual results may vary.
Either way, it’s a lot. You may be able to encourage grandparents, friends and other relatives to contribute to your child’s 529 plan. For 2021, they can generally make annual contributions up to $15,000 a year for a single person and $30,000 for a married couple without triggering the federal gift tax, assuming they did not make any other gifts to the same person. They can also take advantage of a feature unique to 529 plans that allows them to make five years' worth of contributions at once without triggering the federal gift tax4. If they don’t make additional gifts to the same person during the same 5-year period, an individual can contribute up to $75,000 for 2020 and a married couple filing jointly can contribute up to $150,000 (these amounts may change in the future due to cost of living adjustments), provided they make the required election on a gift tax return for the year of the contribution.
Your Unified Lifetime Gift Credit, currently $11.7M, may also be available to fund your account up to the account maximum contribution limit, which varies by state, but can be as high as $500,000.5 However, before taking any action, you should discuss with your legal and tax advisors the consequences of using your unified lifetime gift tax credit to fund your 529 plan contribution and how this impacts your overall estate plan.
This is just one of many ways 529 plans are flexible and can adapt to a family’s changing needs. Also note: Account owners may change the accounts’ designated beneficiaries anytime as frequently as desired and there is no age limit or required minimum distributions.6
Morgan Stanley offers a robust platform of investment options, including the Morgan Stanley National Advisory 529 Plan, a first-of-its-kind advisory 529 plan that enables you to benefit from fiduciary oversight of your education funding strategy within the context of your broader portfolio and life goals. Contact your Morgan Stanley Financial Advisor or Private Wealth Advisor for more information on a 529 plan that may be appropriate for you.
A portfolio of zero-coupon municipal bonds can be a smart way at times to save for college. This type of fixed income security does not pay interest but instead can be bought at a substantial discount to its face value, which it pays in full at maturity, providing a lump sum equal to the initial investment plus imputed interest. A big plus with these bonds: when purchased from a government entity, their interest is often exempt from federal income tax and usually from state and local income tax as well. And if you need a specific amount of funds at a particular date—for example, when paying college tuition—your Financial Advisor can structure your portfolio so that the bonds mature right before payments would be due.
When a gap looms between the cost of education and the ability to pay when due, most families reach for student loans by default. But they’re not always the right option. Interest rates on some student loans can exceed 7%; what’s more, for unsubsidized loans, that rate begins accruing the minute the loan is made, even though payments don’t start until after your child graduates. In addition, student loans are generally not dischargeable in bankruptcy proceedings, and your Social Security benefits may even be garnished to collect balances owed.
Many parents understandably want their children to have some “skin in the game”—and student loans certainly lock in the need for long-term responsibility. But you may want to balance that against the weight of educational debt that many students end up carrying long after graduation.
One strategy that parents often overlook is to borrow against their own assets. Parents can then make a loan directly to their children to pay for education. As a borrower, the child must still bear the responsibility of paying back the loan, which typically may carry lower interest rates. The family “lender” may choose to have the child refinance the loan upon leaving or finishing school, or, if it is not paid back, the “lender” may choose to deduct it from an inheritance or simply forgive the loan to the child.
529 plan account owners may also withdraw tax-free up to $10,000 to pay student loans, which often account owners plan to do if the student successfully completes their studies.
The best-laid plans must account for potential detours. Some children choose to take a gap year for travel, volunteering, or real-world job experience. Others may choose to attend college overseas, or study abroad for a semester.
In many circumstances, you may be able to use 529 plan funds tax-free to pay for those options or some expenses related to them. For example, 529 funds may be used for eligible international schools. Additionally, there’s no time limit on 529 plans. The funds can stay invested and continue compounding while your child explores their passions.
To cover other potential out-of-pocket expenses not eligible for tax-free 529 plan account withdrawals, such as tutoring and test preparation courses, build an educational cost “safety net,” which may include other savings vehicles and an alternative source of credit.
Planning for children with special needs also requires additional considerations and expenses. You may need funds for occupational, speech or other therapies, in addition to educational expenses. For these non-educational expenses, you should consider funding a health savings account (HSA), if you are eligible. These accounts allow you to use pretax dollars to offset medical-related expenses.
You can also set up a special-needs trust that benefits the child. Parents and grandparents may also contribute to such a special needs trust, but should be mindful of potential tax implications at the time of transfer. Be sure to engage a special-needs attorney and consult your tax advisor and Financial Advisor in such cases.
Another option is to open a custodial account for your child, under the Uniform Transfer to Minors Act (UTMA) or similar rules. Assets in the custodial account can be used to pay any types of expenses associated with the beneficiary, including any non-educational expenses, such as any expenses associated with a child who has special needs. Be sure to consult your Financial Advisor to understand the implications of saving for educational expenses through a UTMA, as it may affect financial aid eligibility.
Sometimes the education you wish to fund is your own. If you’re planning to pursue a degree, it may be a good idea to name yourself the beneficiary of a 529 plan and use those funds to pay for your education. There are no age or time restrictions imposed by IRC Section 529 but check if the 529 plan under consideration has any such limitations.
Always keep your overall financial well-being in mind. For example, avoid underfunding your retirement in favor of education. Seek good financial advice to determine the best funding ratios for you and your family, especially if you have multiple financial goals.
Connect with your Morgan Stanley Financial Advisor to identify an education funding strategy that works for your individual circumstances.