Wednesday, November 27, 2013

College Savings

If you're an immigrant like I am, the American college financial aid system looks completely bonkers. Those of us from Asia, which has a more or less egalitarian elementary, middle, and high school education system roll our eyes about the "need-based" financial aid system. Most of Asia runs on merit-based system, because none of the insanity about property-taxed based local schools exist there. The property-tax based school system in the U.S. ensures that the poor remain poor, without much opportunity to qualify for higher education.

That being what it is, if you're a relatively high earner in Silicon Valley, it means that you do have to consider financial planning an essential part of preparing your child for college. Schools like to brag that 50% of their students receive some form of financial aid, which means that the other 50% essentially pay for college out-of-pocket in one form of another. Colleges also frequently include student loans as part of their financial aid packages, and I don't know about you, but I consider loans not "aid", but rather indentured servitude.

The first rule of financial planning for college is to fund your retirement accounts first! This is important because parental assets that are sequestered away in IRAs and 401(k)s cannot be considered in the financial aid planning formulas. Neither are primary residences most of the time. So that means if you're lucky enough to live off a $10M IRA and live in a $5M mansion in Menlo Park, all you have to do is to minimize withdrawals during the years your children are in college and you'll be treated like a trailer-park parent living off social security for the purposes of financial aid. Note that if you were to somehow manage to sequester everything away into your retirement plans and still end up having to spend some money on your child's education from the IRA, IRA withdrawal for paying higher education expenses are not subject to the early withdrawal penalty, though any withdrawal would still be subject to income tax.

The next tax shelter is the 529 account or the ESA. Most Silicon Valley high earners won't qualify for the ESA, but the 529 is available to anyone. The problem with ESAs in any case is that there aren't many low cost options for investing in them. Vanguard, for instance, has discontinued their ESA line of products. My wife writes about some interesting properties of the 529 here. Not only are 529s considered parental assets and therefore aren't as disadvantageous for financial aid purposes as a UGMA/UTMA account in the case where you do qualify for some financial aid. The big feature of the 529 is the tax-free compounding of assets as well as the tax-free withdrawal of gains for the purposes of paying for college education. It's relatively flexible and worth considering.

The final consideration is the UGMA/UTMA custodial account. The advantage here is the the child's investments get taxed at the child's rate. The problem here is that if the child accumulates a lot of assets, that will reduce his or her eligibility for financial aid at a much faster rate than if the assets were accumulated in the parental IRA or 529 accounts. However, if you're confident that your child is not going to qualify for financial aid no matter, then this is a viable strategy for the tax reduction.

Ultimately, of course, none of this matters if your child doesn't want to go to college or ends up being so highly sought after by colleges that they all offer him or her a free ride. In which case you should still fund your retirement accounts first!
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