When it comes to funding future education costs for your children, many people instantly think about college and advanced degrees.
While college is certainly an important part of an extensive educational experience, are you considering private K-12 education? Does your family value a private elementary or high school experience?
The pandemic has spurred a spike in private education, which doesn’t come cheap. According to Private School Review, the average cost in Louisiana for private high school is roughly $8,249 per year, with the average price of elementary school coming in just behind at $6,887 per year for the 2021 school year.
The question now is, how will you pay for K-12 private education?
FUND A CUSTODIAL ACCOUNT
The most common trust for a minor is a custodial account. There are two main types of custodial accounts. Uniform Gift to Minors Act accounts(UGMAs) and Uniform Transfers to Minors Act accounts (UTMAs).
Both are popular vehicles for education saving and allow you to invest a wide array of financial assets like stocks, bonds, ETFs, and mutual funds. A UTMA also permits non-traditional investments like art, real estate, and other collectibles.
There are two primary advantages of using a custodial account:
- Tax-friendly
- Flexible investments
All contributions are exempt from gift taxation (up to $15,000 per year), meaning you can contribute as much as you like in a given year. Earned income up to $2,200 is taxed at the rate of the minor child (which is likely far less than the parent’s effective tax rate).
Additionally, any excess funds not used for K-12 education costs can be redirected for other things such as a first car, college expenses, or trade school.
But, custodial accounts aren’t without their downsides.
Any assets in a UGMA or UTMA technically belong to the child. This loss of control opens up a couple of different cans of worms: financial responsibility and financial aid advantages.
Once the child turns 18, they can use the money however they like. It could be spent on education costs or a fun trip instead, making it critical to prepare your kids to manage and use that large sum properly.
There are also significant financial aid ramifications. Since the assets belong to the child, the federal financial aid formulas consider 20% “available to pay for college.” Compare this number to the much lower rate of 5.6% for parent-owned 529 plans. In general, the more money “available for college,” the less financial aid you receive.
Furthermore, the short time period for investments to grow for K-12 can lead to poor investment results. The shorter the time period for the expense, the safer your investment choice must be and the less growth your investment will produce. While UGMAs and UTMAs provide a lot of flexibility, make sure the downsides don’t outweigh the positives.
OPEN A START K12 PLAN
The most frequently discussed educational saving vehicle is undoubtedly the 529 plan. While 529s are commonly used for college savings, many states offer 529 vehicles for K-12 expenses too. For these types of accounts, parents make after-tax contributions that grow tax-free, and distributions remain tax-free for qualified education expenses. Think Roth IRA savings for school.
In addition to these benefits, Louisiana allows you to deduct your annual contributions from your individual state tax return. Governor John Bel Edwards recently signed a bill that will allow residents to exclude amounts added to the START K12 Savings Plan from their taxable income – up to $1,200 (per beneficiary) for single filers and $2,400 for married couples filing jointly. The bill is a decisive benefit for parents using these accounts to fund K-12 private education.
CONSIDER A ROTH IRA
While primarily slated for tax-free distributions in retirement, Roth IRA funds can help you pay for other significant milestones (including K-12 education).
Many investors don’t realize that they can withdraw contributions (not earnings) from a Roth IRA at any time. For example, if you contributed $5,000 per year for the last ten years, you could withdraw $50,000 for K-12 education costs, tax, and penalty-free.
The beauty of this strategy is its flexibility. If things go well and educational expenses are not as high as you thought, you can simply keep your Roth IRA for retirement.
On the other hand, if costs are higher than expected, you can tap into your contributions without paying a penalty or tax. Roth IRAs are also a good option if you have exhausted your other tax-advantaged accounts (such as a UTMA or 529 Plan).
Remember, you mustn’t jeopardize your retirement savings for educational purposes. Before tapping into your retirement savings, ensure that you have a plan in place to replenish them.
INVEST IN A BROKERAGE ACCOUNT
Lastly, we have the most flexible account of all: a brokerage account.
A taxable brokerage account can be structured to support any financial goal. While these accounts lack any tax deduction, and you will likely pay some capital gains tax over time, you shouldn’t overlook its flexibility.
Very few of us know specific details about our future.
- Will your child prefer a public high school to maintain friendships?
- Will you need additional funds to manage retirement expenses?
- What will the financial landscape of private and higher education look like?
You can address the financial outcomes of these unknowns via a taxable brokerage account (at least to some extent). These accounts provide an outstanding balance to the more traditional educational savings vehicles.
WHY DID WE LEAVE OUT A COVERDELL EDUCATION SAVINGS ACCOUNT?
Coverdell Education Savings Accounts function similarly to 529 plans (after-tax contributions, tax-free gains, tax-free withdrawals on qualified education expenses, etc.). Unfortunately, two significant differences make these accounts far less appealing:
- Income Limits: For married couples filing jointly, the maximum contribution starts to phase out at $190,000 of income and is eliminated for those making more than $220,000.
- Contributions Limits: The annual contribution limit is only $2,000 per year per beneficiary.
With those two points in mind, there is not much appeal to using these accounts for most families.
THE QUEST FOR EDUCATION SAVINGS CONTINUES
As you can tell, saving for K-12 education expenses can get a bit tricky and nuanced. There are quite a few options to choose from, and every family has its own unique circumstances and priorities.
To add complexity to the situation, K-12 expenses are incurred in a much shorter time frame than college expenses. This will impact the way you save and inevitably require a more conservative investing strategy.
Related: How Gen X Can Start off 2021 on Good Financial Footing