Of all the costs associated with raising a child—clothing, doctor’s visits, day-to-day expenses—school can end up being one of the most significant. College tuition prices have risen, on average, over 40% in the last ten years alone and will most likely continue to rise. The cost of private school for years K through 12 is similarly climbing.
Some students may receive support in the form of financial aid or scholarships, but these don’t always cover the full cost of a college education, which can include any number of foreseeable and unforeseeable expenses. Student loan debt continues to burden more than 43 million Americans, whose outstanding balances total over $1.7 trillion.
With this in mind, here are a handful of different tools you can use to save for your child’s upcoming education costs.
Choosing a savings plan
When it comes to saving for your child’s education, the earlier you can start, the easier it will be to reach your goal. That’s because each of the plans described below has an investment component wherein the contributions you make to the plan can potentially grow over time. A modest contribution today could amount to a larger sum by the time your child is ready for school. Let’s take a closer look at a few of the different education savings plans available to you.
529 savings plan
The predominant college savings vehicle is the 529 savings plan, and it’s available everywhere across the US in one form or another. These plans are state-sponsored and can be categorized as either education savings plans or prepaid tuition plans, with the primary difference between the two being how their distributions can be allocated.
In both instances, the accounts are funded with post-tax dollars and those contributions are treated as gifts for tax purposes. The contents of the account can be invested, potentially earning tax-free growth over the life of the investment, and no income taxes are due upon withdrawal as long as the money is spent on qualifying education expenses. Anyone—parents, grandparents, extended relatives, and friends —can open and make contributions to this type of plan. There are no annual contribution limits but keep in mind that annual contributions in excess of the annual gift tax exclusion ($16,000 in 2022) will count against your lifetime estate and tax gift exemption. Alternatively, if you have the financial means to do so, you can front load a 529 plan by contributing 5 years’ worth for a total of $80,000 (in 2022) per beneficiary and per donor without it counting against your lifetime estate and tax gift exemption.
Education savings plan
The standard type of 529 plan, an education savings account functions a lot like other tax-advantaged investment accounts in that it provides incentives that make it easier to save towards your goals—school, in this case. Contributions occur on an after-tax basis and can be made at any time, assuming your contributions don’t put you over your state’s contribution limit if one exists. The funds within your 529 plan are afforded tax-free growth and you have different options for investing them, from stocks and bonds to mutual funds and target-date funds.
You can withdraw $10,000 per year from a 529 education savings account to pay for qualifying education expenses for K-12th grade. If your child goes to a private elementary or high school, your withdrawals can also be used to help pay for this tuition.
If your child doesn’t end up going to college, you can change the beneficiary on the account to one of their siblings or another eligible beneficiary like future grandchildren. Alternatively, you can withdraw the money and pay a 10% penalty plus income taxes.
Prepaid tuition plans
The prepaid tuition plan is designed to help students pay for public, in-state college by allowing them to pay some or all of the tuition costs ahead of time. Your account contributions are invested and guaranteed to grow at the same rate as college tuition costs, ensuring that the contents of the account scale to fit your tuition needs. This effectively limits your ability to earn excess returns, but it also lowers the risk you take on.
In comparison to the education savings plan, you’re more limited when it comes to deploying a prepaid tuition plan’s funds. The withdrawals from this account can only be used for college tuition and fees—they cannot be used for room and board or other expenses commonly associated with university. Additionally, prepaid tuition plans are only available in certain states.
Generally speaking, prepaid tuition plans offer a simpler and less risky alternative to the standard 529 education savings plan, albeit with less flexibility. If your child’s college plans change, you may be able to convert the account into one that helps cover private or out-of-state tuition, but there’s no guarantee that your prepaid plan will cover all of the new tuition costs.
Roth IRA
Although Roth IRAs are most frequently used to save for retirement, they can also be used to pay for qualified educational expenses.
You can contribute to a Roth IRA at any age, as long as you have earned income meet the income qualification rules. If you have a Roth IRA, the contributions (but not the earnings) can be withdrawn at any time—free from income tax and penalty. Once you reach age 59½ and have met the 5-year holding rule, all money can be withdrawn without taxes or penalties for your personal living expenses, including your children or grand children’s education expenses. If you’re not 59½ yet, you’ll owe income taxes on the earnings, but not the 10% early withdrawal penalty as long as the cash is used for college expenses. If you’re planning to use your Roth to pay for schooling, just be sure that you don’t derail your retirement savings in the process.
Custodial UGMA and UTMA accounts
The Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA) provide Americans with two custodial savings accounts that can be used to invest in their child’s education. Contributions to these accounts are made post-tax, and you may contribute up to $16,000 (in 2022) annually without facing a gift tax. Although you may incur some taxes, there is no ceiling on the gifts or transfers you can make to these accounts. Unlike the 529 savings plan, the funds in these accounts are not limited to qualified education expenses; they can be used for clothing, transportation, and more.
Just keep in mind a couple of items – Firstly, when your child turns the age of majority, they will be free to do what they want with the funds, including deciding whether or not they want to pay for higher education expenses. Secondly, UTMA and UGMA accounts may adversely impact the Expected Family Contribution when filing for Financial Aid.
Choosing the right plan
When saving for your child’s education, there are many plans for you to choose from that afford you the potential to grow your contributions over time. As with your other investments, time and discipline are key to achieving these longer-term goals. Getting an early start on all of your kids’ college savings will pay off in the long run, as those accounts will have more time to appreciate by the time they’re needed. Should your child opt out of college, you’ll still have options for alternatively allocating those funds.
If you would like some help deciding which plan best suits your family’s needs, reach out to us and we can help you craft a personalized financial plan.
References
- “529 Plan Basics – Fidelity.” Fidelity Investments, 21 December 2021, https://www.fidelity.com/learning-center/personal-finance/college-planning/abcs-of-college-savings-plans. Accessed 8 August 2022.
- Kuchar, Kristen. “What is an UTMA or UGMA Account? – Savingforcollege.com.” Saving for College, 22 June 2022, https://www.savingforcollege.com/article/what-is-an-ugma-or-utma-account. Accessed 8 August 2022.
- Sleight, Mandy. “How to save for your child’s college fund.” CNET, 15 November 2021, https://www.cnet.com/personal-finance/how-to-save-for-your-childs-college-fund/. Accessed 8 August 2022.
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A 529 plan is a college savings plan that allows individuals to save for college on a tax-advantaged basis. Every state offers at least one 529 plan. Before buying a 529 plan, you should inquire about the particular plan and its fees and expenses. You should also consider that certain states offer tax benefits and fee savings to in-state residents. Whether a state tax deduction and/or application fee savings are available depends on your state of residence. For tax advice, consult your tax professional. Non-qualifying distribution earnings are taxable and subject to a 10% tax penalty.