We reviewed what to expect as US college expenses in the last episode.
We will review how to save that efficiently in this episode.
This episode will be useful only for the US residents.
Others can save yourself 10 mins and listen to some good music.
Hello. My name is Vijay Mohan. You are watching Investment Insights.
From last episode, we know that instate public university tuition fees costs $104,000 on average.
We also know that this need will become $172,000 in 15 years.
How can we save this $172,000? We can check out that calculation in the next tab.
Today’s cost of Tuition - $44,000
Today’s cost of other expenses including room boarding and books - $60,000
Expected tuition inflation rate - 5%
Expected Other Inflation Rate - 2%
Current age of your child - 3
Child’s age at the time of education - 18
Expected return rate, I am assuming as 5% here. You can use a number that fits you.
Current Savings for education, the money we have saved so far for education - let us assume that to be $10,000.
We are seeing the results for these assumptions below.
Future need for education cost - when our 3 year old kid gets ready to go to college, we can expect a total cost of $172,000.
We got 15 years to save this money.
Yearly savings that is needed to achieve this target is what we are seeing as “Yearly savings need” - $7,000.
Copy this calculator to your account and use the numbers that fits your situation.
There are two choices to save this amount tax efficiently for US residents.
First choice is 529 savings plan, as you all know.
529 is a savings plan provided by each state for college savings in USA.
The biggest advantage with 529 is, when we invest money in this account, there is no capital gains tax for the earnings from this investment.
But we can use this money only for qualified education purposes.
Not just tuition fees, but all other education related expenses like boarding and books are qualified as well.
In our example, we saw that for $172,000 need, we need to save $7,000 per year right?
If we have invested this money in 529 every year, we do not have to pay any taxes when we withdraw it to pay for qualified educational purposes.
Instead, If we have invested the same money in a brokerage account that does not have tax benefits,
then out of this $172,000, $105,000 would have been our contribution and the rest $67,000 would have been capital gains.
We would have paid short term or long term capital gains for that.
That tax is saved in this 529 plan. That is the first and foremost advantage of 529.
Next advantage is, 529 is not limited to the colleges in that state, but can be used to pay for any qualified colleges.
Almost all universities in USA are qualified. Some International ones are qualified as well.
You can check for eligible institutions in savingforcollege.com.
When we open the 529 account, we have to choose a beneficiary for that account.
One 529 account can have only one beneficiary.
But after we have saved this $172,000, what if our kids say that they are not interested in college studies like Bill Gates?
What happens to the money then? We have two choices then.
1. We can withdraw the money. But because we are withdrawing for unqualified expenses, we have to pay a penalty of 10%.
That means, for our $67,000* capital gains, we have to pay a 10% penalty of $6,700. (Note: By mistake, I am saying 10% penalty on $172,000)
Other than that, we have to pay tax for that as well.
This is the biggest drawback with 529.
The other choice that we can do, just changing the beneficiary.
That beneficiary could be any one. Could be our other kid or nephew or niece.
The only condition to be a beneficiary is, they have to be US citizen or US resident. That is all.
What many people do is, if they do not need the money for their kids, they will save it for their grand kids.
That will give our $172,000 to grow tax free for another 20 to 30 years.
Remember Power of Compounding? We can send not just one, but many grandkids to college for that money.
We can also score the best grand parents awards as well.
If something happens to the beneficiary or if they got scholarships, then we do not have to pay the 10% penalty for the withdrawal.
But for that earnings, we have to pay capital gains tax.
In that situation, this 529 account becomes like a brokerage account.
OK. How much can we contribute to this account per year?
There is no limit to the contribution. We can contribute as much as possible.
But there is a catch. As far as IRS is concerned, this 529 is a gift from parents to kids.
So this comes under gift tax limitation.
One parent can gift up to $15,000 per year to kids without any tax.
Then both the parents can contribute upto $30,000 per year without any tax.
This is a straight forward contribution.
If we want to contribute more than this, we can do that as well.
But we have to file an extra form 709 while filing taxes for any extra amount that goes over $15,000.
We don't have to pay any extra taxes for that. But this extra amount counts towards lifetime gift exclusion.
That is $11.7 millions per person. That means, any person can gift upto $11.7 million dollars without any tax in their life time.
This extra contribution over $15,000 would count towards that 11.7 million.
Actually there is a way to contribute over $15,000 without getting counted towards this 11.7 million.
It is called 5 year election. We can contribute the total 5 years amount $75,000 in one year.
But we have to fill the form 709 every year for those 5 years showing 5 year election.
99% of us do not have to worry about this gift tax.
But it is important for those 1% high net worth individuals.
Though 529 does not have a limit in yearly contribution, it limits contribution after the account has reached certain maximum value.
That maximum is different for different states. That max limit ranges from $235K to $529K.
Know your state’s maximum limit. In Illinois state’s 529, we can contribute till the account value reaches $450K.
Again, 99% of the folks will not run into this max issue.
We have reviewed the general advantages and disadvantages of 529 savings plan so far.
This is applicable for every state plans.
Other than these, each individual state could provide state tax credit or tax deduction.
That is additional bonus. That benefit is totally different between states.
Here we are looking at the list from whitecoatinvestor.com. Link is in the description below.
We are looking at what is the state tax credit and deduction available in different states.
This is just for a general idea. This does not have to be latest data.
Double check the tax break available in your state.
Important thing to note here is, all these are state tax breaks. Not federal tax breaks.
Money contributed in 529 does not get any federal tax breaks.
But like we already saw, there is no federal or state tax for the withdrawal assuming that we are using it for qualified expenses.
OK. I am in Illinois now. Would I be able to buy just 529 plan offered by Illinois?
No. I can buy any 529 plans offered by any state.
But we should buy the 529 plans with maximum benefit to us.
For me, buying in Illinois is the best option. But how can we find that out?
For that, we can use this cheat sheet from thefinancebuff.com. Link is in the description below.
They have basically grouped all the states based on their advantages.
First group is “Go anywhere states”.
That means, folks in this state can buy 529 plans from any state. You got complete freedom to do that.
There are 22 states in this group under 3 different categories.
First category - states with no income tax. If there is no income tax to begin with, what tax break could they offer in their 529?
Next - states that do not offer tax breaks for their 529. If there is no tax break for buying local state plan, then whats the point in buying local state plan?
Then - states that offer tax breaks - but they don't have the restriction that we have to buy the plans from them.
These 3 categories of states belong in this group.
If your state is in this group, you can buy the best available 529 plan in the market.
We are looking at the list from whitecoatinvestor.com. Michigan, Utah and Illinois plans have got gold rating from morningstar.
Choose the best plan that fits your needs.
Again, the list here could have been outdated. Make sure that you have the latest data.
Next group is “Deduct and Run” states.
To get tax breaks in this state, we have to contribute in their local 529 plans.
But we have the flexibility to transfer the balance to other best plans later.
There is no penalty or taking back the tax break they have already provided (recapture) in these states.
There are 13 states in this group.
Third group is “Home state”. This has the rest of the 15 states.
The 529 plans in these states have tax breaks. But we have to pay back the tax breaks if we transfer the balance to other state plans.
So folks in these states, if you need tax break for contribution, then you can contribute only to your local state’s 529 plan.
Our state Illinois comes in this group. Luckily for me, Illinois plan is one of the best plans. Worked out fine for me.
So depending on which group your state is on, you can choose the best plan for you.
You can have as many plans as you want. If you are in Illinois, it is in home state group.
Every year, it gives a tax deduction of upto 20K per family.
So till you hit that limit, you can contribute to Illinois plan.
If you would like to contribute anything more that year, you have the freedom to choose any 529 plans across USA.
There is no need to stick to Illinois as you have already got the maximum tax benefit for that year already.
OK. We have contributed to 529. How can we invest the money in that account?
That depends on the plan. For that reason, we should be choosing the best plan among others.
Best plans offer cheap index funds. We can choose that.
Or they offer age based portfolios mostly.
Age based portfolios are, depending on the age of the child, the % allocation of stocks and bonds adjusts automatically every year.
Here we are looking at the age based portfolio offered by Illinois.
We can see as the age of the child increases, the % allocation on high risk stocks goes down and less risky bonds goes up.
For automatic investment, portfolios like this is best.
But if you want to manually manage that % allocation, you have the freedom to choose stocks and bonds index funds as well.
Till now we reviewed 529 savings plan. There is a 529 prepaid tuition plan as well.
It comes with too many restrictions. In my opinion, it is a complete waste of time to even look at it in detail.
Even if your state offers that prepaid plan, just focus on 529 savings plan. That is all to a 529 plan.
Other than 529, there is another way to cover the college expenses. That is ROTH IRA.
ROTH IRA? Isn’t that a retirement plan? Yes.
But ROTH IRA has the benefit of withdrawing the contributed amount any time.
So, we can definitely tap into that if we are in need of college expenses that is not covered by 529.
But remember, college education can be funded easily thru a loan. But retirement cannot.
For that reason, think twice before tapping into the ROTH IRA money.
Also remember, ROTH IRA contribution comes ahead of 529 in our investment priority list.
So always max out ROTH IRA before considering 529.
Next episode is going to be a special Q&A episode as we have reached 50,000 subscribers.
I have already posted regarding this in channel community.
Ask your questions in that thread. It has already got lot of interesting questions.
Give thumbs up to good questions.
Of all the questions, I will be answering the top 10 questions with most thumbs up. Thank You.