With kids going back to school, the day when that school has a hefty price tag on it may be getting closer. Many parents are wondering how they can start saving for that day since no one wants to see their child struggle with debt if they can avoid it. While it may not be possible for everyone to fully save for all their children’s education expenses, every little bit can help. (Just make sure you’re on track for retirement first since there’s no financial aid for that.)
Fortunately, an increasing number of employers are offering financial wellness programs that can help their employees save for education. After all, more savings means fewer employees raiding their retirement accounts to pay for college bills. Let’s take a look at some of the pros and cons of several common education saving options:
Regular Savings or Investment Account
This is the simplest option. It’s just a savings or an investment account in your name intended to be used for your child’s education. The main benefit is that it gives you the most flexibility in how the money is invested and used. The biggest downside is that you need to pay taxes on the investment earnings each year, which reduces the amount available for those education bills.
Custodial (UGMA or UTMA) Account
One solution to the tax problem is to open an account in your child’s name since your child is likely to be in a lower tax bracket than you. The problem is that Congress anticipated this strategy for parents to use their children as tax shelters and created the “kiddie tax.” Net unearned income over $2,300 for dependent children this year is generally taxed at the parents’ tax rate.
There are a few other downsides too. While the money doesn’t have to be used for education, it has to be used for the child’s benefit so there are some limits on what you can do with it. Also, 20% of assets in your child’s name can be counted in financial aid calculations, which is much higher than money in your name. Finally, once the child turns the age of majority in your state, they can then use it for anything they want. That can be college bills… or a new sports car.
US Government Savings Bonds
These bonds can be cashed in tax-free for qualified education expenses as long as you meet certain requirements, including income limitations. In particular, Series I Bonds are currently paying 9.62%, are fully backed by the federal government, and do not fluctuate in price. However, that rate adjusts every 6 months with inflation so it will decline if inflation recedes. You also can’t redeem them in the first 12 months and you lose the last 3 months of interest if you redeem them in the first 5 years. You can purchase up to $10k per person per year at treasurydirect.gov plus another $5k per year with tax refunds.
Perhaps the most popular option is a 529 savings plan. These are set up by each state, although you can contribute to any state’s plan regardless of where you live or where your child goes to school. Some states offer state tax deductions or matching funds for residents who contribute to their home state’s plan. (Seven states also provide a state tax break if you contribute to any state’s plan.)
There are several benefits of using a 529 savings plan. The earnings are tax-free if used for post-secondary qualified education expenses (and up to $10k a year for K-12). If you open the account in your name, only up to 5.64% is counted for financial aid purposes and you maintain control over the funds even after your child reaches the age of majority. (A 529 plan in a third party’s name, like a grandparent, doesn’t affect financial aid at all.) It’s also a great estate planning tool since you can give up to 5 years’ worth of gift tax exemptions all at once and the contributions are removed from your taxable estate.
The main downside is that using the funds for something other than qualified education expenses can subject you to a tax and 10% penalty on earnings that you withdraw. There are several outs though. If your child earns a scholarship, you can withdraw the amount of the scholarship penalty-free. You can also use the money for anyone related to your child like a sibling or even you or your spouse if someone else in the family goes to school instead. Finally, there’s no penalty in the unthinkable event that your child passes away.
Another downside is that you’re limited to the investment options offered by the various state plans. Financial guru Clark Howard has set up a guide to what he thinks are the best 529 savings plans based on the investment options and what tax breaks and credits your state may offer. If you’re worried about taking any investment risk, another option is to purchase tuition units in a 529 prepaid tuition plan instead.
Coverdell Education Savings Accounts
This is a plan with similar tax benefits and penalties to the 529 plan and it’s generally treated the same way for financial aid purposes too. However, you have more flexibility in some ways with how the money is invested and used. Like an IRA (see below), you can open it at a range of low cost institutions and invest it anything from an FDIC-insured savings account to individual stocks. In addition to funding post-secondary education costs, you can use this for tuition to a private or religious school that provides elementary or secondary education as well as items like laptops and cell phones even if they’re not required by the school.
They have some restrictions though as well. The biggest is a total contribution limit of $2k per year per child from all sources. There are income limitations on who can contribute, but you can easily get around this by simply gifting the money to the child or someone else to contribute to the account. The money also has to be spent by the time the child turns 30, but if that deadline gets too close for comfort, you can always change the beneficiary to someone related to the child or roll the account into a 529 plan with the same child as beneficiary.
A final option is to use a traditional or Roth IRA because funds can be withdrawn with no penalty for qualified education expenses. However, you’d still have to pay taxes on the money you withdraw except for after-tax Roth IRA contributions and qualified Roth earnings. This also obviously reduces the amount you would have for retirement so make sure you don’t need the money for your retirement goals.
If you’re still not sure which option is best for you, you may want to consult with a qualified and unbiased financial planner or coach. (If the planner makes money by selling products for a commission or charging a fee for the assets they manage, it could influence their advice.) Look for a planner that charges flat fees or see if your employer offers you access to one for free through a workplace financial wellness program.
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