College Planning: The Pros and Cons of Your Savings Options
College is expensive. It is even more expensive when you have multiple kids and want to send each of them on your dime. The sooner you get started with a plan to save and invest, the better you and your children will be when they finally start the application process. If you’re more than ten years from this point, you have plenty of time. If you’re a bit closer, you can do it with a little extra savings each year and by making sure you choose the right account and investments. Some have higher contribution limits which can help you to catch up. Keep in mind that although you have a strong desire to pay for your kids’ education, it is not necessarily your duty. Financial Aid, scholarships, and an old fashioned thing called “work” can get them through on their own. Let’s explore how you can plan and save for college.
We believe that your retirement savings shouldn’t be put on hold in order to fund your child’s education. If you have to move in with your child when you’re 75 years old because you can’t afford rent, that might be a bigger burden than leaving him with a little debt… just saying. If you are fortunate enough to afford saving in both areas, there are more than a few college savings vehicles to choose from that you should review.
In order to determine which is best for your situation, you must first define the goal. How much do you plan to invest now and over the coming years? Each option has its own respective limits. How will the plan affect your taxes? Some college savings vehicles provide upfront tax advantage while others do not. What if your child doesn’t end up going to college; what happens? How conservative or aggressive do you want the investments to be? All of these questions should be considered before selecting the account type.
529 Plan
Contributions made to a 529 plan are not federally tax deductible, but you will receive a tax advantage on the back end; in most states withdrawals are not subject to state tax if used for qualified education expenses for the designated beneficiary. Qualified expenses include tuition, school fees, books, supplies, and room & board for students that are at least half-time. Keep in mind that although these tax-free withdrawals are beneficial, you do not receive any tax advantage for the contributions you’re making now. Also, withdrawals made to pay for items other than college expenses will result in a 10% penalty by the IRS. 529 plans are quite flexible when it comes to your investment choices; with contribution limits up to $300,000 in most states and a variety of funds to choose from, you can customize this plan to fit your needs.
Coverdell Education Savings Account (ESA)
Just like a 529 plan, contributions are not tax-deductible, and qualified withdrawn earnings are excluded from income when used for appropriate expenses. In addition to qualified higher education expenses such as tuition, books, and room & board, K-12 expenses also qualify for tax-free withdrawals. This can be a great advantage if you plan on sending your little one to an expensive private school. With much smaller contribution limits, Coverdell Accounts only allow for $2,000 per year per beneficiary (in this case your child). If you have three kids, you can put away a total of $6,000; $2,000 for each every year. 529 plans have no age restrictions, whereas ESAs restrict contributions to the beneficiary’s account after he or she reaches age 18, unless the beneficiary is special needs. Additionally, these funds must be used for qualified spending before age 30.
UGMA/UTMA
If you have a huge stack of cash or other funds already lying around for your kiddo’s college fund, a UGMA or UTMA might be a suitable place to put it since they both have no contribution limits. Unlike the first two accounts mentioned (529 and Coverdell), a UGMA//UTMA has no special tax advantages, though. In fact, earnings are taxed to the minor/beneficiary each year. When the minor reaches the age of majority, he or she can then use this money however they want. If you doubt your child will make the choice to spend this money on college and that is your intention, be careful with these types of accounts. Keep in mind that there are no tax advantages on the spending later, either. One advantage we see with these accounts is the ability to transfer/gift money to your child or grandchild. Once transferred or gifted, the money is theirs (not yours) though you can name yourself custodian and manage the investments on their behalf. This can be useful for certain tax or estate planning strategies.
Qualifying U.S. Savings Bonds
Remember those things your grandmother gave you when you were a kid that you always wondered about? Well, those things are still around. U.S. Savings Bonds are tax-deferred for federal and tax-free for the state. Certain post-1989 EE and I bonds may be redeemed federally tax-free for qualified higher education expenses. When redeemed by your child at a later date, there is no penalty in addition to the taxes owed if they do not use this money for something other than education. U.S. savings bonds are backed by the full faith and credit of the U.S. federal government, meaning these things are as safe as it gets. You don’t have to worry about market risk and instead can count on a fixed rate of return over X number of years. Limits are $10,000 (face value of the bond) per year, per owner, per type of bond.
IRAs
You probably automatically think of “retirement” when you think of IRAs. Well, that’s because an Individual Retirement Account is meant to help you save for retirement. What many might not realize, is that if early withdrawals are taken for qualified educational expenses, there is no penalty. Limits are low ($5,500 if you’re child is under 59.5 years old). Hopefully, they are! Otherwise, they may have missed the boat with this whole mom-and-dad-pay-for-college idea. The point to keep in mind here is if you’ve already set up a Roth or Traditional IRA for your kids, you might not need to open a separate college fund; you can use this money to pay for college. Keep in mind that contributions can be deductible or not depending on how the account was set up. Withdrawals will be taxed if it’s Traditional, but not if it is a Roth.
Now you may be thinking to yourself, “Okay, great. I have options, but how do I choose, and then how do I open it and select the investments inside the account?”. That’s what a Financial Advisor is for. There’s a lot more that goes into planning for college than just opening an account. If you know what your budget is, start here to determine what you can afford to put in monthly or annually. Start somewhere; even $200 per month over ten years could turn into almost $40,000 if invested in a fund that achieves average results. Considering what you plan to put away, compare the contribution limits between each of the aforementioned accounts. If you want to be aggressive and diversified with your investment selections, savings bonds alone won’t be right. These are just some examples of things you should think about as you start your plan.
Remember, saving for college is not necessarily more important than your own retirement. If you have extra income that is not needed to meet your retirement goals, put money away for the kids. Also consider the fact that there are plenty of non-traditional college options. Taking online classes will obviously cost less than driving to a fancy campus five days a week, and certainly, cost much less than bunking up in a dorm room. There are plenty of good options out there. Do the best you can to save without sacrificing higher priority goals. And if you need some guidance and support, please let us know. That’s what we’re here for.
Get started with saving for college. Contact us.
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. This information is not intended to be a substitute for specific individualized tax advice. Neither SagePoint Financial Services, Inc., nor its registered representatives, offer tax advice. As with all matters of a tax related nature, you should consult with your tax professional. Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits. IRA strategies implementing various tax strategies or tax codes may not be appropriate for all investors. Please consult your investment and tax professional prior to implementing a strategy. A Roth IRA distribution is qualified if you’ve had the account for at least five years and/or the distribution is made after you’ve reached age 59½, because of your total and permanent disability, in the event of your death or for first-time homebuyer expenses. Distributions made prior to age 59 1/2 may be subject to a federal income tax penalty. If converting a traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted traditional IRA contributions and on all earnings.