5 Ways to Save for Your Child’s College Education
Wondering how to save for your child’s college education? Maybe you’ve heard of a 529 College Savings Plan but are wondering if their are other education funding options? Keep reading to learn five different ways to save for college and how to decide which is right for you.
Congratulations parents! You’ve successfully navigated the baby-crying, middle-of-the-night feeding, diaper-changing, potty-training, screaming-for-no-apparent-reason, tantrum-throwing, car-seat-resisting stage of life. Now it’s time to make the next most important decision of your life: how to send your little rascal (I mean, sweet little child) to college.
If you talk to a financial planner, you’ll likely get advice that goes something like this:
Decide where your little one is going to go.
Figure out the current price.
Adjust for inflation.
Figure out the total you’ll need to save.
Convert that to a monthly amount to save.
Done! See isn’t that magical? Wait, I’m supposed to save HOW MUCH?!?! That’s more than my food budget for the month!
Yeah, the reality is a little different, huh? That process probably works out for a few people who have tons of money and a good idea of where their child will want to go. (PS: if you want to find out how much you should save for college, savingforcollege.com has a great online calculator .)
It’s not that financial planners are wrong, it’s just that it is hard to predict the future and to save as much as is needed.
For those of us who don’t have money coming out of our...ears, the process is a little more haphazard. Many people I know have opened 529 plans for their children and are just doing their best to put money in it as often as possible. And honestly, that’s not a bad strategy.
But maybe you’re wondering if that’s the right option for you or if there even ARE other options (there are).
Before we jump into the five ways to save for college, I want to acknowledge that not everyone is lucky enough to be able to stash money away for their child’s college education. If you are in a position where you just can’t find the funds, take a deep breath. This doesn’t make you a bad parent. Just do the best you can and celebrate whatever wins you have in your financial life, even if it is just survival. And when it comes time for your young one to apply to college, make sure you fill out the FAFSA. Many colleges might be financially out of reach, but there are plenty that are willing to give aid to those who need it.
5 Ways to Save for College
529 College Saving Plans
If there’s one college savings option you’ve heard of before, it’s probably this one. 529s actually come in a couple of different kinds. A few places actually have prepaid tuition plans where you pay in advance for your child to attend a particular school, but most people tend to go with the 529 savings plan since they’re more flexible and more widely available. That’s what we’ll be describing here.
What is it?
A 529 is a special account that allows you to set aside money for qualified education expenses, including tuition, books, fees, room and board, etc as well as up to $10,000 per beneficiary per year for private K-12 tuition and up to $10,000 (lifetime limit) for paying off student loans.
If you use the money for these qualified education expenses, you don’t have to pay any taxes on the growth portion when you take it out. This is a fancy way of saying that 529s give you a tax break when used properly. If you use the plan sponsored by your state, you might even get a state income tax deduction on contributions. Even MORE tax savings.
529s are a great option because they can be used by anyone, you can put a lot of money in them, they offer decent investment options, and you get some good tax benefits.
In terms of financial aid, a parent-owned 529 counts as a parent asset. This means that you will be expected to contribute 5.64% of the account value toward college tuition each year.
You might want to consider another option, however, if you’re not sure your child will go to college or won’t need the money for whatever reason. If you don’t end up using the money for qualified education expenses, you can either transfer it to another related beneficiary or withdraw it and pay a 10% penalty and taxes on the gains (but not on the amount you contributed in the first place; you get that back for free).
Coverdell Education Savings Account
Coverdell ESAs are similar to 529s in terms of how they work. You put money in the account, let it grow, and withdraw it tax-free for qualified education expenses.
The difference is in the details. Coverdells are only for those under a certain income threshold and have more restrictions on how they can be used. You can find more information here.
So why would you want to use a Coverdell instead of a 529?
First, they’re a better option for those within the income limits who are trying to pay for private K-12 education expenses. Where a 529 can only be used for tuition (up to $10,000), a Coverdell can be used to pay for other school expenses such as tutoring, supplies, uniforms, or even transportation.
Second, Coverdells have more flexibility in terms of investment options. You could invest in individual stocks if you wanted to. 529s only allow you to invest in a select number of pre-chosen options, usually mutual funds. Whether that’s good or bad is a discussion for another time… (and something you should discuss with an investment advisor).
Roth IRAs
Wait, aren’t Roth IRAs for retirement? Why yes, they are. But there’s no penalty for using funds from a Roth IRA to pay for higher education expenses (just make sure you follow the rules).
Roth IRAs are great from a tax perspective and offer a lot of investment flexibility. If you time your withdrawals strategically, they’re also great from a financial aid perspective. Roth IRAs are nice because if you don’t end up needing the money for tuition, you can keep letting it grow tax-free for retirement.
Roth IRAs do have some downsides, however. First, if you’re under age 59 ½, you still have to pay income taxes on the withdrawals (but no penalty for education expenses). Second, Roth IRAs are subject to income limits, so not everyone can contribute (though a backdoor Roth IRA might be an option). Third, contributions are limited ($6000 in 2021, or $7000 if you’re age 50 or older). And finally, you have to be strategic about when you use Roth IRA money to pay for college.
Roth IRAs don’t count as a parent asset when calculating how much financial aid you get from filling out the FAFSA. That’s great! But, if you take money out of it, the withdrawal counts as income and will reduce the amount of financial aid you get. To get around this, you’ll want to avoid using Roth IRA money to pay for college until the spring of the sophomore year.
Plus, you should probably be using the Roth IRA to save for your own retirement.
If you’re considering using a Roth IRA to pay for college, I would highly recommend talking to a financial planner just to make sure that you’re on track to meet all of your financial goals, maximize investments, and minimize taxes and financial aid impact. This doesn’t mean they’re a bad option; it just means they’re complicated and I wouldn’t want you to accidentally make any mistakes.
UTMA/UGMA
I’m just going to state up front that these aren’t a good option if you’re fairly confident your child will go to college and that you will qualify for need-based financial aid. If that’s you, I give you full permission to skip over this section. If you’re not sure or you’re just curious, read on!
UTMA stands for the Uniform Transfer to Minors Act and UGMA for the Unified Gift to Minors Act.
What does that mean? Well, you know how some rich kids have trust funds? These are sort of an easy way to set up a trust for a minor. UTMAs and UGMAs are custodial accounts where money or assets are given to the child, but the child can’t access it until age 18 or 21 depending on the state and account type. If you set up one of these for your child, you can’t take the money back or transfer it to another child. And once the child reaches age 18 or 21, you have no control over what they do with the money.
The nice thing about UTMAs and UGMAs is that they offer a lot of flexibility in how the money is used and invested. UTMAs also allow a way to transfer non-monetary assets such as real estate. They can also potentially provide some slight tax advantages to wealthy families in that some of the investment income will be taxed at the child’s tax rate instead of the parent’s.
While UTMAs and UGMAs technically can be used for college savings, they’re probably not the best choice for most families. They have several disadvantages:
Income generated in the account will be taxed even if used for education purposes.
They have a bigger negative effect on financial aid. UTMAs and UGMAs are considered child assets, which means that 20% of the account balance will be included in what you are expected to pay for college each year. That’s higher than if the money was owned by the parents (including in a parent-owned 529 plan).
The student gets full, unrestricted access to the entire amount upon the age of majority (18 or 21, depending).
So why would you use one?
Since UTMAs and UGMAs can be used for anything, they provide a lot more flexibility, especially if your child doesn’t go to college or gets a full scholarship. Some families who are unlikely to receive any need-based financial aid might like to have at least part of their college savings in one to hedge against the risk their child doesn’t need all the 529 money. And sometimes families have special situations where it makes sense to have the child own the assets.
Bottom line: they’re really not the best option for anyone who thinks it is likely their child will go to college and qualify for financial aid. For anyone else, it’s a good idea to work with a financial planner and/or accountant to understand how this will affect your taxes and other aspects of your financial plan.
Brokerage Account
A brokerage account is just a regular account used for investing that offers no particular tax advantages for education and can be used for anything. They offer the most options in terms of where you can open the account and what investments you can buy. And you can use the money for anything you want whenever you want.
For financial aid purposes, brokerage accounts owned by the parent are considered parent assets. This means that 5.64% of it will be counted toward the family contribution each year. This actually makes a brokerage account more advantageous than an UTMA or UGMA, which are student assets (of which you will be expected to contribute 20% each year). Brokerage accounts will have the same financial aid impact as a 529 or Coverdell, provided they are all owned by the parent.
Brokerage accounts are not as tax efficient as a 529 or Coverdell because you do have to pay capital gains and/or income taxes on the gains in a brokerage account. However, it’s important to note that this tax impact is greater for families with higher income. For example, a family who files taxes as Married Filing Jointly doesn’t pay any capital gains taxes until they make over $80,000 (2020). So higher income families get more tax benefits from a 529 than lower-income families.
That said, it can be nice to have the flexibility of saving in a brokerage account. They also make a nice compliment to other savings options in order to provide a balance of flexibility and tax benefits.
Other Options
I know I said there were five ways to save for college, but I feel I should at least mention two other methods that are sometimes sold to families: permanent life insurance and non-qualified annuities (those that are not part of a qualified retirement plan).
Permanent life insurance is one of the most divisive topics in the financial planning world. While there is a role for permanent life insurance in terms of asset protection and estate planning, permanent life insurance comes with high fees and complications that make it less than ideal for college savings. If you have a policy and want to use it to help pay for college (by withdrawing cash value or taking a loan against it), that might make sense and you should work with a financial planner to make sure that’s the best option for you.
But using permanent life insurance to save for college just typically isn’t the best way. For more information, check out this article from savingforcollege.com.
(Note: this discussion is limited to permanent life insurance and does not apply to term life insurance.)
Similarly, non-qualified annuities have some advantages for retirement savings (such as the ability to protect against outliving your assets), but come with high fees and limited investment options. In addition, they may or may not actually be beneficial from a financial aid standpoint. Learn more here.
Keep in mind that insurance agents make a lot of money off of permanent life insurance policies and annuities. If you are considering either of these, please talk to a financial advisor who is a fiduciary (someone committed to working in your best interest, not theirs) about whether these insurance products make sense for your situation.
Which college savings plan is right for you?
There’s no one right answer for everyone and it’s impossible to know for sure what will end up being the right decision. You don’t know if your child will go to college or how your financial situation will change. All you can do is make the best decision you can with the information you have available now. Remember, you can always do a combination of options and change your strategy over time.
This chart from the American Institute of Certified College Financial Consultants education program gives a good overview of the five best ways to save for college in terms of their operational flexibility, investment options, tax efficiency, and effect on financial aid.
Simply saving any money in any of these accounts will have more impact than getting the account type exactly right. So if you’re doing your best to save, pat yourself on the back for a job well done and take comfort in knowing you’re doing your best.
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