The Non-Plan College Savings Plan

shutterstock_223506652 (2)In honor of National Save for College Month, I thought I would share some of my best ideas for saving for college that don’t actually involve a government sanctioned, IRS approved, state sponsored “savings plan”.

Here they are:

Pay off your mortgage. If you can free up an extra $200 – $1,000 each month, you may be able to cash flow a big chunk of your kids’ college expenses. Paying off your house or other debts may be the surest way to do that.

By the time you factor in what you already spend on your kids, a reasonable amount for them to contribute from their own pocket, as well as any scholarship or financial aid dollars they may qualify for, the extra cash flow you get by paying off your mortgage could be just enough to fund your college expenses for the next 4 years.

One advantage of this strategy is that, unlike many other assets, your home is an exempt asset on the FAFSA financial aid form. By paying off your mortgage you reduce the amount of money that you must report on the FAFSA form, and potentially increase your eligibility to receive financial aid for college.

If you worry about losing the tax deduction, don’t. By the time you get down to the final years of your mortgage the tax deduction usually isn’t very significant anyway.

You can use this strategy with other debts as well. Paying off your car, home equity line of credit, credit cards, etc. all work toward achieving the same goal – freeing up monthly cash flow to help pay for college.

Max out your 401(k). Maxing out your 401(k) can be an effective way to save for college. Here’s why: If you can save more for retirement when you are young, you may be able to afford to scale back your retirement savings during the years in which your kids are in college. Plus, the earlier you start maxing out your 401(k), the better off you will be in the long run.

True. Scaling back on your retirement plan contributions may not be the greatest tax or retirement planning strategy. You need to know how this strategy affects your other long-term goals, but if you are ahead of pace on your retirement savings, you might be able to afford to contribute less to these plans when cash flow is tight.

Build up your non-retirement savings. 401(k) plans and other tax-deferred retirement accounts are a great way to save for retirement. However, after a couple of decades of saving for retirement many families find that nearly all their savings is in pre-tax retirement plans and their liquid savings is nearly non-existent. When it comes to tapping their savings to pay for college they have nowhere else to go.

Saving into a brokerage account or mutual fund in your own name provides a college nest egg that can be tapped into with minimal tax consequences. Typically such savings are taxed at the lower capital gains tax rate rather than ordinary income tax rates. For some families capital gains may actually be tax-free. Most of us will pay 15% of the gain on our investments in taxes.

Contribute to a Roth IRA. Roth IRAs allow parents the opportunity to bridge the gap between paying for college and saving for retirement. Since they are funded with after-tax dollars, Roth IRAs grow tax-free and the principal is available at any time, for any reason without tax or penalty. If you are over 59 ½ and you have owned the Roth for 5 years or more all distributions are tax and penalty free – regardless of what you use the money for.

Not 59 ½? No problem. The principal is still available without tax or penalties. A $5,000 annual contribution for 12 years adds up to $60,000 that may be used for college or other non-retirement purposes. If you are married multiply that by two.

Certain restrictions do apply. If your income is too high, you may not be able to contribute to a Roth IRA. To see whether you qualify to contribute to a Roth, click here.

Another issue to consider is financial aid. While the Roth IRA is an exempt asset, distributions count as “non-taxed income” on the FAFSA form. If you expect to receive a Pell Grant or other types of need-based financial aid, distributions from your Roth IRA may reduce the amount of aid you qualify for.

Save in your kids’ names. Financial aid experts will tell you to never save money into your kids’ names. However, if you don’t expect to receive need-based financial aid, UTMA accounts can offer an effective way to save money for college.

UTMA or Uniform Transfer to Minors Accounts allow people under the age of majority (typically 21 in most states) to own stocks, bonds, mutual funds and other securities with a legal adult (usually a parent) as custodian of the account.

The advantage of UTMA accounts is that the first $2,000 of earnings are tax-free. The IRS taxes the next $2,000 of earnings at the minor’s tax rate. Any taxable amounts above that are taxed at the parents’ tax rate. If you manage these accounts carefully, taking tax-free gains every year, these accounts are very tax efficient — maybe even tax-free.

UTMAs also offer fewer investment limitations. Buy your favorite stock or mutual fund. Create your own portfolio. Trade as often as you want. Invest as much or as little as you want. Do whatever you like. Unlike other types of savings plans, UTMA accounts typically have very few restrictions on how the assets are managed as long as they are managed in a way that is in the best interest of the minor.

UTMA accounts have two main drawbacks. First, they count as a student’s asset on the FAFSA form. In plain English, if you expect to get need-based financial aid for college, UTMAs will reduce your eligibility to qualify for that aid.

Another big, sometimes really big, disadvantage is that when the minor reaches the age of majority the money in an UTMA account is theirs to do with as they wish. They don’t have to use the money for college and you don’t have the ability to change beneficiaries. Legally, the money in these accounts belonged to them all along, but when they turn 21 they take over and you give up all authority on the account.

The non-plan savings plan. Other more traditional savings plans have their place, but if you implement this non-plan savings plan, you will be debt free, on-track for retirement, and well-funded for college.

You may even have a few dollars left over for yourself. Now that’s not a bad plan at all.