How To Save For Child’s College
When it comes to college savings, there’s no shortage of confusion….
What will college cost when they get there?
How much debt will they/you need to take on?
What is the best way to save for their college?
When is the best time to start saving for college?
It’s great that you’re here right now, because that means that you’re thinking about your child’s college education, and ready to find the best ways to save for it.
First up, you need to pick the right savings vehicle. Picking the wrong one could mean that your child misses out on financial aid opportunities, or costs them tons in taxes that could have been avoided.
Financial Aid is usually determined from the parent’s and student’s income and assets during the student’s Junior year of high school, but the student’s income and assets carry greater weight than their parent’s, so when at all possible, it’s usually more advantageous to keep college savings in the parents names (using tax-advantaged savings accounts) to avoid missing out on financial aid.
But the flip side of choosing a college savings vehicle is that you can use one to your and your child’s advantage to make their college experience a less painful, and hopefully debt-free one.
There are 5 main savings vehicles for college:
- 529 Plans
- Prepaid Tuition Plan
- UTMA & UGMA Accounts
- Roth IRA
- Coverdell Education Savings Account
Arguable the most popular way to save for your child’s college is through a 529 College Savings Plan.
Prior to 2019, 529 Plans could only be used for college education expenses, but changes in the tax law will allow 529 Plans to be used for K-12 expenses as well. For the purposes of this article, we will explain how a 529 can be used only for college savings.
A 529 College Savings Plan allows parents to save for their child’s education using pre-tax dollars. Funds can be invested in a variety of ways, including age-based packages that take on higher risks when the child is young, and moves funds to safer investments as the child approaches college age. This is the same way Target Date Retirement funds work, so chances are you’re familiar with this concept already in your 401(k) plan or other investments.
These plans can yield big tax advantages for the parents during their working years, and big Financial Aid advantages for the student when they apply for it.
All funds deposited into a 529 are pre-tax. Then, they grow tax-free, and as long as the funds are used for college-related expenses, there will never be taxes paid on any of the funds or their growth. Even better, the funds in the 529 belong to the parent, not the student, so if one child does not need all of their allotted 529 funds, the funds can be redirected to another child to pay for a larger-than-anticipated college tuition bill if necessary. And, because the funds are in the paeent’s name, they are not listed as the student’s asset, and therefore will help them qualify for more financial aid.
But all of the freedom of a 529 Plan comes restrictions:
- Funds can be withdrawn tax-free only for qualified educations expenses (tuition, books, fees, supplies, room and board)
- Money spent on unqualified expenses is subject to income tax and a 10% penalty on earnings
- Investment allocation can only be changed twice per calendar year
Prepaid Tuition Plans
Traditionally used at a state university near the student’s home, prepaid tuition plans are exactly what they sound like: tuition paid in advance of enrollment.
By paying for their education now, the parents lock in tuition prices, which protects you from sharp rises in the price of tuition even if your child is years away from college.
Unfortuately, not every state offers prepaid tuition plans, but it’s definitely worth looking into, especially if you (like us) will be stipulating that your child needs to attend a state university in order for you to foot the bill.
Gains on prepaid tuition plans are usually exempt from Federal taxes, and if your child decides to attend an out-of-state school, all investments and their growth are fully refundable, making them an awesome investment for your child’s college.
UTMA & UGMA Custodial Accounts
If you’re unsure of whether your child plans to attend college, or for another reason is not at risk of losing financial aid because of assets in their name (financial aid looks at how much money the student has to his/her name as part of the equation to determine how much aid they get), then a 529 or Prepaid Tuition Plan is not a good option. These plans lock money into only being used for educational expenses, but you want more freedom than that.
UGMA stands for Uniform Gift to Minor Account.
UTMA stands for Uniform Transfer to Minors Act.
In these accounts, the taxes get a bit complicated:
- First $1,000 in gains is tax-free
- Second $1,000 is taxed at the child’s income tax level.
- The remainder is taxed at the parent’s income tax level.
In these accounts, there are no restrictions as to how these funds may be used, provided they are used to benefit the child.
However, there is a downside.
In UGMA and UTMA accounts, the parents have no control over the money after the child reaches the age of 18, because under the law the money is theirs. While the child is a minor, the parents controls the money.
If you want to give your kids a head start on retirement savings – that could be used for college if necessary, with minimal tax impact – opening a Roth IRA for them is a great option.
Once he or she begins earning an income, they can have a Roth IRA, and 100% of their income, up to $5,500 can be deposited in the account, which will grow tax free.
The downside is that the funds deposited in a Roth IRA are post-tax, so an income tax return must be filed at the end of the year for the child, and taxes paid on their income.
While your child is under 18, you retain control of the accounts, but after 18, control reverts to the child. However, the law requires that withdrawals not be made from a Roth IRA until the age of 59 1/2.
With that being said, Roth IRA funds can be withdrawn without penalty for a few reasons:
- Education expenses
- Purchasing a first home
- and others, found here
Coverdell Education Savings Account
In the right circumstances, a Coverdell Education Savings Account is a great option for college savings.
These accounts, also known as an ESA, allow you to invest tax-deferred for your child, and withdrawals are free from federal income tax so long as you use the funds to pay for qualified education expenses.
These qualified education withdrawals apply for education expenses all the way from kindergarten to college. These accounts are incredibly flexible, but there are some restrictions, namely that only $2,000 per beneficiary can be contributed per year.
Additionally, only those who make $220,000 or less per year (filing jointly) can use an ESA, but an ESA can be used in conjunction with a 529 plan.
Here’s the lowdown….
Some parents may not want to save for their child’s college. (We are actually in this camp).
We would like our daughter to “embrace the struggle” of college by applying for as many scholarships as possible, working during high school and college, keeping her living expenses low, and being mindful of the costs at the college she chooses to attend – if she chooses to go at all. After all, there is no shame in trade school, and apprenticeship, or on-the-job training.
But with that being said, we don’t want her saddled with debt after her education, assuming she makes wise choices.
And we would LOVE to have a nice sum of money set aside for her to do with as she wishes, whether pay for college, a wedding, a house, invest, or whatever else she feels is a wise decision.
However, not saving anything is not something that’s on our radar at all.
So no matter what level and type of savings you’re planing for your children, it is wise to explore all of the options and see which one fits your family best.
How and what are you planning to save for your child?
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