Savings for College: 4 Strategies to Consider
While education might be priceless, it isn’t free. According to data reported to U.S. News, the average college tuition for the 2019-2020 school year ranged from $41,426 (for private colleges) to $11,260 (for state colleges). These figures do not include room and board, in addition to other expenses, such as books, computers and travel, which can significantly increase the total amount needed to attend college.
Few parents have an extra $40,000+ on hand, so how can families today start saving for their children’s college fund? Or, if they’ve already begun saving, what additional strategies can they put in place to make that fund grow even faster?
Named after the section of the Internal Revenue Code that governs it, a 529 plan, also known as a “qualified tuition plan,” offers families a tax-advantaged way to save for education costs.
There are two types of 529 plans: educational savings plans and prepaid tuition plans. Educational savings plans, which are sponsored by states, allow families to open an investment account on behalf of their child, who can then use the money for not only tuition and fees but also room and board and other qualifying higher-education expenses at any college or university recognized by the Department of Education.
While the money can usually only be invested in mutual funds and exchange-traded funds, the underlying benefit is the tax savings, which vary according to state and plan. Generally, families contribute after-tax money to the 529 plan and the earnings grow tax-free.
A great benefit of a 529 plan is that families are not limited to their state’s plan — they can contribute to a 529 plan in any state that offers one. Further, a 529 plan can be used for schooling in another state. For example, if you live in Florida, you can contribute to a Texas 529 plan and use the funds for a college in California. Families can do their research to find the best plan that works for them, including the particular tax advantages.
The other type of 529 plan, the prepaid tuition plan, as its name implies, is simply a way to prepay tuition and fees at a college at current prices. This locks prices in early, potentially saving families thousands of dollars. Usually offered by public institutions, the downside of this strategy, however, is the unknown — whether or not the child will want to attend the chosen university and has the academic achievements to be accepted.
Coverdell Education Savings Account
Another investment vehicle for college savings is a Coverdell Education Savings Account (ESA), which allows families to set up a savings account for someone under the age of 18 to pay for qualified education expenses.
The advantage of the Coverdell ESA is the breadth of asset classes available to the account holder. In a 529 plan, funds can generally only be invested in mutual funds and exchange-traded funds. However, in the Coverdell ESA, the investor can select stocks, bonds and a variety of different asset classes.
While both college savings plan types allow assets to grow tax-free, contributions to a Coverdell ESA are not tax-deductible. Further, it’s important to note that the Coverdell ESA plan is only available to people who make less than an adjusted annual gross income of $110,000 for an individual, or $220,000 for a married couple filing jointly. Also, the annual contribution limits to a Coverdell ESA are low: only $2,000 per year per beneficiary.
Traditional or Roth IRA
Families often tap existing investment and retirement accounts to pay for their child’s education. Traditional and Roth IRAs are no exception, and can be used to fund college tuition and expenses.
Investors contribute after-tax dollars with a Roth IRA, but do not pay taxes on the money when they withdraw it. If you’re over age 59½, you can withdraw money for any reason, including funding your child’s college expenses. There are usually penalties for withdrawing funds before age 59 and a half, but if you’ve had and contributed to the account for at least five years, you can still take out earnings to pay for qualified higher education expenses without paying the 10% penalty.
Like the Roth IRA, the traditional IRA also waives the 10% penalty for withdrawals used for qualified higher education expenses before age 59 and a half, but you do have to pay income tax on the withdrawals.
It’s also important to understand the contribution limits for both types of IRA accounts: for 2021, if you’re under age 50, it’s $6,000 per year and if you’re age 50 or older, it’s $7,000 per year, which includes a $1,000 catch-up contribution.
UGMA and UTMA Accounts
As another investment vehicle for college savings, families can open a Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account on behalf of a beneficiary under 18. Though not specifically created as a college savings account, the assets in these accounts will transfer to the minor when he or she becomes an adult (at age 18 or 21, depending on the state).
The benefit of this account type is flexibility: there are no contribution or asset class limits, and the child may use the funds not necessarily on qualified education expenses at a traditional college or university. A downside is that there are no guaranteed tax benefits.
While it’s never too late to start saving money for a child’s education, the earlier a family starts, the more of a chance the money has to grow. It’s also important to know that different types of accounts vary with respect to contribution limits, tax advantages, withdrawal penalties and permissible asset classes. You want the funds to grow, but there might be upside limits and downside risks.
Also, if you do apply for financial aid, keep in mind that the funds in these accounts will be counted as assets, and may affect eligibility.
Before you launch a college savings plan for your kids, it’s important to have other financial ducks in a row. For one, you should pay off high credit card balances or other high-interest debt, and ensure that your credit scores are at the highest level possible. This is for planning purposes, in the event that your child needs to apply for student loans and needs you to co-sign. You would not want poor or even fair credit to have an impact on a lending decision.