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If you’re like most Americans with school-age children or grandchildren, you may be wondering how you can ever save enough money to send them to college. Every year you hear that college costs are rising more than inflation and that, 18 years from now, it will cost a lot more to send your child to public or private school. My son is almost two, and the cost of college is already on my brain.
Even if you can’t save a lot, you can still take advantage of a college savings plan. With this in mind, I thought it would be helpful to take a look at some popular ways to save for college. I condensed the information into 10 questions people frequently ask me about college savings.
1. How can I estimate future college costs?
The FinAid.org cost calculator can help you figure out how much a particular college will cost at the time your children or grandchildren will attend. It’s a little more generic in nature, but it can give you a good sense of what the basic costs might be. In working with clients, I also have a software program that I use that has a list of most colleges throughout and you can get a real sense of what the estimated cost for an actual college might be.
2. Why start a college savings plan early?
The longer you wait, the more money you’ll need to save to meet your goal. By the time today’s newborns are set to enroll in college, four years at a public university will cost more than $200,000. While getting an early start is key, it’s never too late to begin saving for the educational objectives of those you care about. Doing so can make a meaningful difference — by potentially reducing the amount you or the account beneficiary may need to borrow to pay for school.
3. What are some tax-advantaged ways to save for college?
Section 529 savings plans and Coverdell Education Savings Accounts are the two most popular ways to save for college. Many investors also use custodial accounts such as those authorized under a state-sponsored Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). There are pros and cons to which would be best. Most notably, is if the child does not go to school. Typically, what I see is for parents that what to save some money for the child, but don’t want to force them to go to school, the the custodian account works best. Reversing the situation, and you’ll see the other two being used, most commonly the 529 plan then Coverdell Education Savings Account.
4. What is a 529 savings plan?
Named after Section 529 of the Internal Revenue Code, 529 college savings plans provide a tax-advantaged way to save for qualified higher education expenses. These plans are generally sponsored by individual states, while plan assets are professionally managed by independent investment firms or state government agencies. Anyone can open a 529 savings account regardless of income level and contribute up to $13,000 ($26,000 for married couples) a year without gift-tax consequences.
5. What are some features of Coverdell Education Savings Accounts?
Coverdell Education Savings Accounts have been offering tax-free withdrawals for higher education since 1998. Unlike 529 savings plans, withdrawals can be used for elementary and secondary education and even for academic tutoring and education-related computer expenses.
There are income restrictions though. If your modified adjusted gross income (MAGI) is less than $110,000 ($220,000 if filing a joint return), you will be eligible to contribute to a Coverdell account. Annual contributions are also limited to $2,000 a year.
6. Can I invest in both a 529 and Coverdell account?
Yes, investments in a 529 savings account will not affect your ability to invest in a Coverdell Education Savings Account for the same beneficiary. Investing in both can be an especially good idea because the two complement one another. It’s similar to having a retirement plan at work and then also having an IRA, as well.
7. Are UGMA and UTMA accounts still good choices?
For many years, UGMAs/UTMAs were the only substantial education savings vehicles available, so many investors have built up sizable amounts in these accounts. UGMA/UTMA accounts do not have income or contribution limits. And, at least part of your earnings may be exempt from federal income tax. Some or all will be taxed at the child’s lower rate if the child is under age 18.
Contributions to UGMA/UTMA accounts are irrevocable, meaning that once the money or other property has been given, you cannot change your mind and withdraw the gift.
You can withdraw money anytime for the benefit of the child — not just for education. The child assumes control of the account upon reaching the age of majority (18 or 21 in most states).
8. Do gift-tax rules apply to college savings plans?
Contributions to 529 savings plans, Coverdell Education Savings Accounts and UGMA/UTMA accounts are subject to gift-tax rules. Under these rules, you can contribute up to $13,000 a year ($26,000 for married couples) without gift-tax consequences.
Under a special election, you can invest up to $65,000 ($130,000 for married couples) to a 529 account at one time by accelerating five years’ worth of investments with no federal gift-tax consequences. If you make this election, additional contributions or other gifts to the same individual over that five-year period will exceed the annual gift-tax exclusion.
9. What if my child does not go to college?
With a 529 savings plan, you can leave the money in the account in case your child decides to attend college at a later time. Or you can select a new beneficiary, including yourself or anyone who is a member of the current beneficiary’s family. If you take the money out for anything other than education, you will pay ordinary federal income tax plus a 10% penalty on the earnings. Keep in mind that the 10% penalty does not apply to scholarships. This means that if your child were to receive a scholarship, you would be able to withdraw the scholarship amount of the account without getting penalized.
With a Coverdell account, the beneficiary must use the assets by the time he or she reaches age 30, or a new beneficiary must be named.
For UGMA/UTMA accounts, you will owe capital gains tax whenever shares, stocks or bonds are sold.
10. What do you use for your child?
Currently, we are using an out of state 529 plan because I felt it offered better investment options. I will in the near future start an in-state plan as well, just as another level of diversification. While helping our kids through college is on our minds, we do not expect to fund the full tuition. If we have the money we will, but we also want our child to appreciate the gift of education.
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I don’t like the idea of using a 529 plan to save for a child’s education. I’ve been working on a way to teach my children some important lessons about saving, planning, and debt, and I think that college is the first real opportunity to do so. Although I plan on saving money to pay for their education, I wonder how much more seriously they would take it if they were under the impression they were paying for it themselves? After having a few discussions with some other folks, I think the best option (as of now) is to use some other investment vehicle (in case college just doesn’t happen), and loan them the money. Once they graduate, they have to pay you back in full. Olivia over at independentbeginnings.com shared an idea to refund your child for each on time loan payment after the loan has been paid back to you. I really like this idea as it ties in well with how I want to introduce my children to the stresses and obligations of debt before they build any consumer debt of their own.
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Adam-
That’s a struggle I deal with myself. I completely funded my own way through college thanks to the National Guard and put great value on the education I received. My wife’s parents were in a financial situation where they were able to pay her way (without saving for it, just through their income) all the way through. Both of us turned out fine and have good paying jobs, so trying to figure out what the “right” way is a question that we have not answered yet. I do know that if my child wanted to go out of state to a private university, I would like him to have that opportunity because that never would have been an option for the both of us. I don’t think there’s a right or wrong answer, just a happy medium depending on what you want for your child.
So we have been contributing the max (both our retirement & kids college money) to our Roth IRA, since we are currently not paying taxes. My husband says that we can withdraw the principal from our IRA for education expenses at any time and not pay a penalty. Then we would use the “extra” money and interest as our retirement when the time came. Is this a good idea? Should we be doing something else also or instead?
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I think that’s an excellent idea. Sometimes people get caught up trying to fully fund their children’s education and forget about their own retirement. A Roth IRA (if eligible) will allow you to do both. One thing to keep in mind is that although you avoid the penalty when taking it out for college expenses, you will still be taxed on any gain above the initial contributions. Luckily, you can elect to take out the contributions first. This obviously differs from the 529 plan where it’s all completely tax free. If funding your children’s education is a priority, then you might want to incorporate a 529 plan in the mix, as well.
Why not use Roth IRA?
a. it is completely under your control
b. all earnings and dividends are tax-free, no capital gain tax.
c. it does not affect financial aid eligibility
d. after 5 years the account first set up, the contribution can be taken out tax free for whatever reasons.
e. if you are over 59.5 years old, withdraw the money for whatever reason.
Traditional IRA can also be used for education before age 59.5 years old.
529 is a law to create more investment products rather than helping financing education. Most 529 programs have poor returns. All these 529, Education IRA, etc are cumbersome, either too restrictive for contribution, or only set up for rich families or rich grandaddies.
@ Sidney
A Roth IRA could make absolutely sense, but there are a few things to consider. 1. There are phaseout limits. So not everybody would be eligible to contribute. With the 529 plans, this would not apply. Addressing your points:
a. Absolutely right.
b. Correct, but earnings that are pulled out for qualified educational expenses will be taxed, just not penalized
c. Very True
d. The contributions can be taken out at any time, and are not subject to the 5 year rule. That just applies to the earnings. Those then fall under what I stated in b.
e. That’s one benefit of the Roth. If your kids don’t use it for school, at least now you can a tax free nest egg waiting for you at retirement.
The 529 plan does need some work. Personally, I would like to see a universal account just as the Roth IRA.
There are good 529 plans, you just have to do your research. And contributions to 529’s are rather simple. Coverdell ESA’s have more income restrictions.