For many parents, the Spring months are full of happy news, as high school seniors announce their college choices. For parents of younger children, however, those happy announcements may make them wonder if they are being savvy about starting to save for college.
One thing any parent will tell you is that time flies. Before you know it, your toddler will be taking the SATs. And one thing any financial advisor will tell you is that the earlier you start any savings plan, the better off you’ll be (although any time is better than no time.)
Not all college savings plans are created equal
The good news is that more parents than ever are already saving, including an impressive 65% of young millennial parents, according to Sallie Mae’s 2016 report How America Saves for College.
Unfortunately, 61% of the parents surveyed said they are putting their savings in regular savings accounts, and a whopping 44% of all money saved is held in savings & checking accounts, CDs, savings bonds and other low-yielding instruments. And too many of the non-savers are hoping that earnings from their own investments or savings will cover college.
So what are the best ways to save for your child’s education?
Better Ways to Save – 529s, ESAs, and UTMAs
With the availability of excellent plans with significant tax benefits and the potential for compound interest gains, why are so few parents taking advantage of them? One reason may be that the various plans, while excellent, are not always easy to understand. Even the alphabet soup of names is daunting when you’re also worried about packing lunches, soccer practice, and missing work for parent teacher conferences.
Here’s a simplified look at the top plans:
While 529 plans have been around since 1996, they still seem to be a well-kept secret, with only 22% of college savings invested in these portfolios of investment funds (here too, savvy Millennials are leading the charge with 44% planning to take advantage of 529 plans, while Gen X and Baby Boomer parents trail at 36% and 23%.)
529 plans are offered by each of the 50 states and allow you deposit post-tax money that grows and compounds tax-free. While you can invest in any state’s plan, investing in your own state’s plan may offer state income tax deductions in addition to the federal tax break for earnings.
Advantages: Anyone can create a 529 account (including the future student) and anyone can add up to $14,000 per year to the account (or $28,000 if married) without paying a federal gift tax. Up to a total of $400,000 can be invested in a 529 plan account per beneficiary (each state sets its own limits) and for most plans there is no age restriction for the beneficiary. They also allow withdrawals to pay for educational supplies such as computers and books, and the account owner can change the beneficiary to another eligible family member if the funds aren’t used.
Potential drawbacks: when you invest in a state plan, you do not control the financial decisions. Instead, you invest in the portfolio of funds offered by the plan. So shop around for the state plan you feel most comfortable with and that best matches your risk tolerance (a good Fiduciary Financial Advisor can help you evaluate the choices.)
Coverdell Educational Savings Accounts (ESAs)
ESA accounts are similar to a 529 plan in that you contribute post-tax money then growth in value is tax-free. Unlike 529 plans, however, you are free to invest the money as you please.
Advantages: You control the investments in the account and, like 529 plans, can use the funds to pay for educational supplies such as computers and books. You can also use ESA funds to pay for K-12 costs if your child goes to a private school. Any funds not used, may be rolled, tax-free, into the ESA of another family member.
Potential drawbacks: Contributions are capped at $2000 per year per beneficiary and must come from contributors whose adjusted gross income for that year is less than $110,000 (or $220,000 for individuals filing joint returns) so this option is not available to higher income contributors. The beneficiary must be under 18 when it the ESA is created and funded, and the funds must be used by age 30 or be subject to federal tax and a 10% penalty.
UGMA/UTMA Custodial Accounts
The UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) allow larger gifts to be made to minors, while still qualifying for gift tax exclusion. They allow a parent or grandparent to reduce their estate for tax purposes with greater flexibility in how the money is invested than a 529 offers.
Advantages: Custodial accounts have the greatest flexibility. You can contribute as much as you want, invest it as you please, and – while 529 accounts and ESAs are exclusively intended for education expenses – funds in a custodial accounts can be used for any purpose.
Potential drawbacks: Unlike 529 plans and ESAs, the earnings are not tax-free. And, while custodian controls how the funds are used while the student is a minor, after the student turns 21 (or 18 in some states,) control is transferred to the student. Another important consideration for both taxes and financial aid applications is that custodial accounts are considered the child’s assets and the income they produce (over $1,050 and up to $2,100) will be taxed as income to the child, then any earnings beyond that are taxed at your rate.
Prepaid tuition plans
If you live in a state with excellent state schools, prepaid tuition plans may be a smart solution for you. Administered by the individual states, these investment accounts allow you to pay for – or contribute to – your child’s future state school tuition at today’s rates.
Advantages: Paying now is a great hedge against rising college costs and the increase in value is not taxed.
Potential drawbacks: The funds can only be used at state schools and do not cover room and board.
Get a head start on your child’s financial education too
Once you’ve chose the plan – or combination – that makes the most sense for you, it’s a smart idea to share your investment plan with your child, as soon as they’re old enough to understand. If you get them started early understanding the power of planning, saving, and compound interest, they’ll already have an A+ in financial literacy when they get into the college of their dreams.
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