As soon as your child is born (if not earlier) you start dreaming about the ways to set them up for success in life. Wanting to save for their college expenses is a common goal for young parents. Odds are, you or your spouse (or both) know first hand how difficult it is to pay off your student loans. For those of you that are lucky enough to be able to save for your child’s education, here is a list of the 9 best ways to save for college.
1. Savings Account
The easiest and most familiar way to start, is opening a simple savings account at your bank. You may already have a savings account in your name. While this might be a familiar and convenient way to start, it also comes with a lot of problems.
Add to Your Existing Savings Account
Let’s say little Johnny is born. The very next day, you start to save a little extra money into your savings account. You should be proud of yourself!
While this might be a great place to “strike while the iron’s hot”, you should quickly find a new place to save.
First of all, by not earmarking a special account for this goal, you have a very slim chance of the money lasting long enough to fund their college. We all have emergency expenses that come up and rarely does our budget ever end up the way we planned. Slowly, you’ll dip into the account for life’s daily expenses.
Open a Joint Account with Your Child
Another option, is to open the account jointly with your child. In the back of your mind, you can say “This money is for Johnny”! This is an easy, convenient way to set up an automatic savings transfer. You can see the account right there when you log into your bank profile.
The drawback to this method is when it comes to applying for financial aid. If you child has too much in savings when it’s time to apply, it could negatively impact how much he can receive.
Plus, as soon as Johnny is able, he can withdraw those funds, no questions asked.
2. 529 Plan
The 529 plan is likely the most recognized way to save for college expenses. It provides a host of benefits, like tax savings, parental control, no limitations on the school or even who benefits from it.
Most states provide a 529 plan. Here is list of all the states’ plans and what they offer.
For those of you that are ready to AGGRESSIVELY start making contributions to your child’s college education, 529 plans allow you to transfer up to 5 years worth of gifts into the account all at once. The annual gift exclusion is currently $15,000 per person, per year. In other words, each person can gift $75,000 in the first year.
While this would be part of a gifting strategy for the uber wealthy, it can benefit the child. Instead of investing $15,000 per year over those 5 years, the entire $75,000 would be invested, providing additional years of tax free growth.
A second, and more down to earth tax incentive is what happens when you start to draw money out of the 529 plan. When you make a contribution to the plan, you’ve already paid income taxes on those dollars. But, as the investments inside of the account grow and earn income, those taxes are deferred, just like an IRA. You won’t get a 1099 telling you to include those dividends on your tax return.
When you pull money out of the 529 plan, as long as you are using those dollars for qualified college expenses, then you STILL don’t have to pay taxes. This is similar to a Roth IRA. The money comes out completely tax free.
That being said, if the money comes out for other, non-qualified expenses, then not only do you have to pay taxes on those withdrawals (like you would from an IRA), but there is a 10% penalty! So, while this is an incentive to go to college, it’s also a disincentive to use the money for other expenses.
Depending on your state of residence, there may be an in-state plan that offers tax and other benefits which may include financial aid, scholarship funds, and protection from creditors.. Before investing in any state’s 529 plan, investors should consult a tax advisor.
When you open a 529 plan, YOU are in control. It doesn’t have to be you, though. It could be a grandparent, another relative or even a close friend of the family. The beneficiary, little Johnny, cannot access the account without permission.
Helpful with Financial Aid
If the account is owned by a dependent student (meaning little Johnny, whom you support financially), when the time comes to apply for financial aid, then the asset is actually considered to the parent’s asset.
If your child has too much in his or her name, then it starts to take away from his financial aid package.
Now, if the account is owned by someone OTHER than you or your child (Grandpa for example) then the withdrawal from the account is considered income for the purpose of applying for financial aid the following year, which could actually REDUCE the aid package.
No Restrictions for Choice of School
When you use a 529 plan as your way to save for college education, then you’re giving little Johnny the ability to attend ANY school he wants. In the next section, you’ll learn about a Prepaid Tuition Program (also under section 529 of the tax code) that would require your child to go to school in-state in order to benefit.
This probably sounds like a good thing for some of you. I understand…you don’t want your baby to move away! But, having less restrictions while being able to enjoy the benefits is actually a good thing.
No College, No Problem!
If your child decides that he or she doesn’t want to go to college, then you can simply change the beneficiary.
Remember, if you don’t use the funds for qualified expenses, then you’re penalized 10% of the amount withdrawn AND you pay taxes on the gains. Changing the beneficiary would avoid those penalties and taxes because the funds can still be used for college.
If you have a younger child, let’s call her little Janie, then you can name her as the beneficiary and use the funds for her education expenses. As the owner, you can continue doing this as many times as the plan will allow, usually just once per year. Maybe you eventually use the savings for grandkids?
Not Just for Tuition
Some of these savings options only allow you to pay for tuition in order to get the benefits. A 529 plan provides the tax benefits for “qualified expenses”. This broader definition includes:
- Tuition and Fees
- Room and Board
- Text Books
Some things that do NOT qualify are:
- Student Loan Payments
- Travel to and from School
- Cell Phones and other “General” Tech
- University Health Insurance
- School Gym Memberships
Like everything else, it’s not all roses and rainbows. There are some negatives to the 529 plan. I’ve already mentioned the restrictions and tax penalties.
As I already mentioned, If withdrawals from 529 plans are used for purposes other than qualified education, the earnings will be subject to a 10% federal tax penalty in addition to federal and, if applicable, state income tax.
Additionally, these plans typically have a higher set of fees associated with them. The investment options are also restricted to a selection of funds, which naturally have a fee associated with them.
Also, the fact that you are invested brings inherent risk. You could potentially find yourself in a market dip right before your child starts college. It’s important to note that the closer you get to your goal, your investment choices should be more conservative because you have less time to make up for market dips.
There will likely be funds available that adjust the risk of the portfolio the closer you get to the target, but they will usually have a higher fee associated with them.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses, summary prospectuses and 529 Product Program Description, which can be obtained from a financial professional and should be read carefully before investing.
3. Prepaid Tuition Plan
An alternative to the 529 plan investment account is the Prepaid Tuition Plan. It’s no secret that college tuition is increasing at an incredible rate. Utilizing your states prepaid tuition plan allows you to lock in the price of tuition.
Look at it this way, if you were to put your savings into a 529 plan, or any investment for that matter, you’d have to GUARANTEE a 7% return on your investment each and every year to match the power of this plan.
There are roughly 11 states that offer the Prepaid Tuition Plan. As of the time this article was written, those states are:
In order to get the full benefit of the Prepaid Tuition Plan, little Johnny will have to go to an in-state college. That might not sound bad to you now, but what happens if they REALLY want to go to another school?
You can still use the savings for that out-of-state school, BUT you won’t get the benefits of the locked in tuition. Either you or your child will have to come up with the rest of the cost OR take out a loan.
Another downside, is you can only use it for tuition. Unlike the 529 plan, you cannot use these dollars for things like books and room & board.
4. UGMA or UTMA Savings Accounts
The “Uniform Gifts to Minor’s Act” and “Uniform Transfers to Minor Act” have created a couple of savings accounts that can be used as a way to save for college. There are a few benefits to using these accounts, balanced by a few drawbacks.
These accounts are in the name of your child, but controlled by you, the custodian. The accounts have absolutely no restrictions as to how the funds are used. The funds can be used to pay for anything you want.
Additionally, there are no limitations on how much you can transfer into the account nor are there limitations to how the account is invested.
At age 18, the UGMA account will be turned over to the child and there is nothing you can do about it. The UTMA account delays it until age 21.
Unlike the 529 plan, you cannot make changes to the beneficiary of the account after it’s opened.
5. Roth IRA
You may be wondering how this retirement account can be used to fund your child’s college education? Well, if you’re getting a later start, this type of account could be a great way to save for college while also having a great backup plan.
You can open a Roth IRA for a minor as long as they are EARNING income. In most states (if not all? ) you can start working before you turn 18. For me, I started working at Office Max at age 16 as a Customer Service Rep. I was basically a glorified stock boy that helped customers along the way.
Anyway, normally, when you contribute to a Roth IRA, you must wait 5 years AND wait until you’re 59 1/2 to withdrawal from the account. If you don’t, you will receive a 10% penalty from the IRS.
The Roth IRA will allow you to make withdrawals for certain expenses. The purchase of a first home is one, and qualified college expenses is another.
Even if the funds were only invested in a money market, earning a couple of percentage points, it still provides SOME tax savings.
Additionally, the value of the account is not included in the calculation for financial aid. Withdrawals from the account will be included as income in following years, however.
Now, because you probably cannot open this account until later in your child’s life, you won’t be able to make a significant amount of contributions that would make up for the late savings. The maximum contribution for 2018 is only $5,500 and will barely scratch the surface for most colleges and universities.
The good news, if they don’t end up going to college, you’ve kick-started the retirement savings process much earlier than most of us ever did. It will teach your children important concepts about savings at an early age.
6. General Investment Account
You may prefer to use a simple investment account for your child. If you don’t want to set rules around what they use their savings for, then here is a good option.
You could set this up as a UGMA or UTMA account and have a similar effect. If you want to retain a level of ownership however, you’ll have to set up a joint account with little Johnny.
The account wouldn’t be handed over at age 18 or 21. They will have access to it, but so would you.
Because this account is in their name, if the account value gets too high (currently $3,000 for his or her share), then it will start to chip away at his financial aid.
The same issues as a joint savings account exist. The difference is that you can invest the funds for longer term growth, while providing a teaching opportunity on the risks of the stock market.
7. US Savings Bonds
Another option, if you’re looking for some tax incentives, is the Series EE or I Bond. As usual, there are are some guidelines to follow, but if you’re most comfortable with something that’s backed by the United States itself, this might be your cup of tea.
To me, this feels like something my grandfather would have done. But, the fact is it’s still an option.
US Savings Bonds are tax deferred for federal income tax purposes and state tax free. If they are redeemed for qualified college expenses, the federal taxes are also free.
There are phaseouts in getting these tax benefits however. What this means is in 2018, when you earn $117,250 as a couple, the benefits start to get lower until you reach $147,250 when they are phased out all together.
So, if you fit within that income window, and find comfort in knowing your bonds are backed by the US government, then this could be at least be one of the ways to save for college for your child.
8. Coverdell ESA
The Coverdell Education Savings Account is another tax friendly savings vehicle. There are definitely some benefits to using an account like this, BUT there are income limits you need to pay attention to.
This way to save for college can provide tax free savings. You can save $2,000 per year into an ESA. The savings can be invested however you like and the withdrawals are tax free if used for qualified education expenses.
You’re not restricted to JUST college either. You can use the funds for any school, K-12 included. Just like the 529 plan, the account is considered to be your asset, and not your child’s when it comes to applying for financial aid.
The downside is that you’re limited to $2,000 per year in savings, which doesn’t get you very far. Additionally, once you start earning $190,000 as a couple, the benefits begin to phase out.
9. Family Gifts
What better way to save for college, than to use other people’s money!
As I mentioned before, grandparents and just about anyone else can start and contribute to the 529 Plan, UGMA accounts and UTMA accounts.
They can also make payments to the school DIRECTLY! We each get a $15,000 annual gift exclusion. But, if you gift directly to a school OR a medical facility, there’s no limit to how much you can gift.
If you have a “rich uncle money bags” or your parents or grandparents want to help out, tell them to cut a check to the school.
Sports Fan, Movie Buff, and Anything Outdoors sums it up. Brad loves spending time with his wife, Ashley, and their two boys. He helps empower people to take control of their money, bringing them the confidence to build the life of their dreams.
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About Matt & Brad
They are identical twins and money experts. Matt and Brad Ruttenberg have, combined, over 2 decades of experience as financial planners. They are known for simplifying money and helping others go from living paycheck to paycheck to thriving financially.
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This communication is strictly intended for individuals residing in the states of Florida, Michigan, Arizona, Nevada, New York, Ohio, and South Carolina. No offers may be made or accepted from any resident outside the specific states referenced. Registered Representative Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. The Money Twins and Ruttenberg & Company are not affiliated with Cambridge.