There seems to be no end in sight to the rise in college costs. For 2018-2019, the College Board reports that the average out-of-state cost for room, board, tuition and fees at a public four-year institution came to $37,430 per year; the in-state cost was $21,370. The same bill at a private, nonprofit four-year institution came to $48,500.
If you have a child born in 2019, the estimated cost of four years of college in 18 years will be somewhere between $222,500 and $438,000, depending on what kind of school they end up choosing.
A quick Google search for college savings plans will surface many references to state-offered 529 plans. These have a number of widely promoted features but for the Muslim investor, 529 plans have one major drawback: they are not halal.
Luckily, you are free to choose other plans that will allow you to achieve your college savings goal in accordance with your personal values. Let’s take a look at the pros and cons of the three major options: Coverdell ESAs, UTMAs and 529 plans.
Coverdell ESAs Offer Tax-Free Savings but Are Limited
Coverdell Education Savings Accounts (ESAs) offer a tax-deferred and potentially tax-free savings option if used for college expenses or other education expenses. But eligibility and contributions are limited.
- Sharia Compliant Coverdell ESAs are halal, allowing practicing Muslims to invest in this education savings option.
- Broader uses Coverdell ESAs can be used to save for education expenses from kindergarten through college.
- Tax benefits Earnings and withdrawals are tax-free if used for qualified expenses for taxpayers who don’t claim an American Opportunity credit or Lifetime Learning credit for the same expenses in the same year.
- No estate tax Once the annual gift has been made to the Coverdell ESA, the money is no longer considered part of the parents’ or grandparents’ estate for estate tax purposes.
- More investment options Coverdell ESAs also have a wider range of investment types that are eligible to be contributed to, or purchased by, these accounts, which could be attractive to a knowledgeable, self-directed investor.
- Low contribution limit and possible confusion Coverdell ESAs have a low annual contribution limit of $2,000. This is the total amount that all individuals can contribute to one account – or to multiple Coverdell accounts for the same beneficiary – in any year. Unless all family members know what others are contributing and how many accounts have been opened, it can be easy to make an excess contribution. In that case, the holder of the account would owe a penalty.
- Limited eligibility Coverdell plans have income limits for contributions. The ability to contribute to a Coverdell ESA begins to be phased out for single tax filers with modified adjusted gross income (MAGI) of $95,000, and the ability to contribute ends completely at MAGI of $110,000; joint filers are phased out with MAGI of $190,000 to $220,000.
- Loss of control Most Coverdell ESAs require the child’s parent or guardian to be responsible for the account. As a result, a grandparent or other relative would no longer have the option of transferring the money to a different beneficiary, or of withdrawing the money if needed for other purposes.
529 Plans May Be Popular but They Are Not Halal
Offered through state programs, 529 plans are tax-advantaged vehicles that are designed to encourage saving for a beneficiary’s higher education expenses. Although widely promoted, they are not aligned with Islamic values and can entail a number of tax and performance issues.
- Tax breaks Although contributions are not deductible, earnings in a 529 plan grow tax-free and will not be taxed when the money is taken out to pay for college.
- Low maintenance Most plans allow you to ‘set it and forget it’ with automatic investments that link to your bank account or payroll deduction plans.
- Simplified tax reporting Contributions to a 529 plan do not have to be reported on your federal tax return, and you won’t have to report taxable or nontaxable earnings until the year you make withdrawals.
- Not Sharia compliant As mentioned earlier, 529 plans do not align with Islamic law. Because they are run by states, they are restricted to mutual funds that are preselected by the state. These funds generally include shares in companies with non-compliant income sources, as well as bonds and other interest-based (riba) investments.
- Restrictions and penalties The funds invested in a 529 plan can only be used for education-related expenses. If the money is withdrawn for any other purpose, you will incur a 10 percent penalty and will owe income tax on the account’s earnings.
- Gift and transfer tax repercussion Contributions are treated as a gift to the named beneficiary for gift tax and generation-skipping transfer tax purposes. This can be a problem if the contributor was planning on making other gifts to the beneficiary during the same year.
- Poor performance In recent years, 529 plans have lost much of their appeal due to poor investment performance. Some ShariaPortfolio clients have liquidated their low-performing 529 funds and redeposited them into UTMAs in order to have a better chance at making gains.
- Mutual-fund fees and expenses Fees are typically higher in 529 plans because of additional record-keeping requirements.
UTMAs Are Both Sharia Compliant and Unrestricted in their Use
UTMA stands for the Uniform Transfers to Minors Act, which is the legal provision in many states that authorizes a custodian to hold assets on behalf of a minor child until the child reaches the age of majority — typically either 18 or 21.
- Sharia compliant While each 529 plan has a specific list of investment options, there are many more choices for UTMA accounts, including mutual funds, individual stocks and sukuks, real estate and precious metals.
- No restrictions on use of the funds The money in a UTMA can be used for anything benefiting the child without affecting the tax treatment. The assets can be applied towards tuition but could also pay for a wedding or set up a business, as long as the expenditure is for the benefit of the child.
- Capital gains UTMAs provide a modest benefit with regards to capital gains that an individual account under the parent’s name would not.
- Wealth transfer UTMAs are a good strategy for passing wealth from one generation to the next. Parents can contribute up to the annual gifting limits of $15,000 ($30,000 for couples) annually gift tax-free.
- If desired, restrictions can be applied Parents concerned with the use of a UTMA can create a Family Limited Partnership (FLP). This allows the custodian to take the UTMA money and buy limited partnership units that can be controlled through liquidity restrictions, such as the child maintains a certain GPA or uses the funds solely for education expenses. To learn more about the specific mechanics behind a trust fund or Family Limited Partnership, please consult an estate planning attorney.
- Financial aid eligibility UTMA funds are considered the child’s assets, which can negatively affect how much aid the child might receive. However, parents who are in good financial standing end up having to pay most college costs one way or the other, since financial aid programs are need-based to help low income families, and merit aid is generally allocated without need-based considerations.
For more information about setting up the right tuition saving plan, please call us at (321) 275-5125 or send us an email at email@example.com.
Investing in securities involves risk, and there is always the potential of losing money when you invest in securities.
Halal compliant investments, diversification and asset allocation do not ensure a profit or protect against loss.
This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.