GET SMARTER ABOUT SAVING for college
You've been meaning to put some thought into how to pay for college when your kids get older, but they're keeping you so busy right now, that there's just no time. Not to worry, we'll get you conversational on this topic in just a few minutes.
If you've got 1-minute: OK, here are the basics. There are several options out there--among them are setting aside money in a general investment account and using a tax-advantaged investment account intended specially for education expenses (like a 529 Plan). When deciding how much and where to save, it's helpful to crunch the numbers to get an idea of how much college might actually cost, to be aware of the benefits and limitations of different savings options, and to think about saving for college in the context of other financial goals you may have.
If you've got 15 minutes:
I LIKE TO KNOW WHAT MY OPTIONS ARE...SO WHAT'S OUT THERE?
There are many possible ways to save for a college education. The following is a list of a few of the more popular savings vehicles, along with some of the pros and cons of each. Not included on the list below are regular savings accounts and IRAs. Want to dive in deeper? Check out the Further Reading section below.
A tax-advantaged investment account authorized by Section 529 of the Internal Revenue Code, specifically intended for qualified post-secondary education costs
The taxes you'd normally pay on the earnings from your investments are deferred, and distributions are tax-free when they're used used for qualified post-secondary education costs
Some states allow you to deduct contributions from your state income taxes
The account owner (usually parents or grandparents) control the account on behalf of the beneficiary (usually the child)
- You can change account beneficiaries, so if you don’t use the money for one child, you can use it for another member of the beneficiary’s family
There's a 10% penalty when distributions aren’t used for qualified expenses
Assets are considered on the FAFSA which will reduce a student's financial aid package, however, they're considered a parental asset which is assessed at a lower rate than a student asset
- Investment options can be limited and some plans carry high fees which can significantly cut into your earnings
- Contributions are treated as a gift to the named beneficiary for gift tax and generation-skipping transfer tax purposes, but the contribution qualifies for the $14,000 annual gift tax exclusion (2016)
Prepaid 529 Plan
A 529 plan that lets you pre-pay all or part of the costs of an in-state public college education, locking in today's tuition rates. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges.
You buy credits or contracts for college tuition at today's rate, and redeem them in the future when tuition rates will presumably be much higher, given recent trends.
Depending on future tuition costs, these programs can potentially offer a good value. Prepaid tuition plans have no investment options. Instead, the price of the contract is determined by a number of factors, money is pooled and invested, and when a child is ready to go to college, the plan transfers funds to cover the tuition directly to the institution.
The account owner controls the account on behalf of the beneficiary.
You can change account beneficiaries, so if you don’t use the money for one child, you can use it for another member of the beneficiary’s family.
Only a limited number of states offer these programs.
Your principal plus earnings may not cover tuition and fees if the student decides to attend a private or out-of-state college or university.
if your child chooses not to go to college and a sibling doesn't use the plan, or you need to cancel the prepaid plan, most plans will only give you back what you originally contributed with a reduction or elimination of any interest earned. Some plans also charge a cancellation fee.
- The expenses covered are narrower than a regular 529, including only tuition and fees.
- Some states offer no guarantees that the plan will fund the future cost of tuition or that the state will step in should the plan falter.
Coverdell Education Savings Account
A tax deferred account dedicated to saving for education expenses (both college and K-12 expenses)
The taxes you'd normally pay on the earnings from your investments are deferred, and distributions are tax-free when they're used used for qualified education costs
- Your investment options aren’t as limited as 529 plans. You can self-direct investments, much like a self-directed IRA
- You can make tax-free withdrawals to pay for private elementary and high school expenses, as well as post-secondary school expenses
There's a $2000 annual contribution limit. If your total contributions exceed $2,000 in a year, there's a penalty
There's a 10% penalty when distributions aren’t used for qualified expenses
Assets are considered on the FAFSA which will reduce a student's financial aid package, however, typically they're considered a parental asset which is assessed at a lower rate than a student asset
There are income limits that impact the ability to contribute to these accounts
- Distributions from an ESA are always paid to the beneficiary and cannot come back to parent
UTMA/UGMA Accounts (Uniform Transfer to Minors / Uniform Gifts to Minors)
These are custodial accounts that allow you to save on behalf of a child for education (or any other purpose that benefits the child) until they reach the age of majority in their state
Because the assets are considered the property of the minor, these accounts are often used to take advantage of the “kiddie tax.” This tax allows a certain amount of a minor’s income to go untaxed, and an equal amount to be taxed at the child’s tax rate (as opposed to the parent's rate)
- There's no penalty if account assets aren't used for college
Contributions are irrevocable and you can’t change beneficiaries
Upon reaching the age of majority, the beneficiary can use the assets for any purpose—educational or otherwise
There is a significant impact on federal financial aid. The account is treated as the child's asset and weighed more heavily in financial aid calculations
- Contributions aren't tax-deductible and earnings are subject to federal income or capital gains tax
US Savings Bonds
EE and I bonds purchased after 1989 by someone at least 24 years old may be redeemed tax-free when the bond owners, their spouses, or dependents pay for college tuition and fees
Interest earned may be exempt from federal income tax if bond proceeds are used to pay the beneficiary's qualified education expenses, provided certain other conditions are met
Since the bonds are backed by the federal government, (hopefully!) the rate you'll earn is guaranteed
- You retain control of the bonds as long as they are owned in your name
Bond proceeds not used for the beneficiary's qualified higher education expenses will be taxed
- Your income must be below a certain level at the time you redeem the bonds to be eligible to exclude the interest earned from federal income tax (yet you must add bond proceeds into your total income for the year when determining whether you meet this income threshold)
Note, there are other ways you could fund your child’s college education. Some people also do it through their IRA or through insurance policies. Many people save for college via traditional savings and investment accounts.
how much should I be saving?
When answering this question for your situation, there are a few key considerations:
The cost of college in the future. There are several calculators out there that can help you project how much college will cost at public and private schools by the time your child is ready to apply. Check out a few listed in the references section at the end to get a sense for what the overall cost might be.
How much of that cost you want to fund. Once you know how much college might cost, you can figure out what portion you want to pay. Do you want to plan to fund all of a four year private school education, part of a public school education or maybe something in between? Here, consider how much you can afford, where saving for college sits versus your other goals, and how you feel about some of the unknowns involved (what kind of school will my child get into?). When you're considering this question in conjunction with what type of account to use, remember that some accounts have penalties if you don't use the funds you save for education, so you have less flexibility to change your mind as some of those unknowns unfold and your circumstances change.
What your savings rate will be. When you start saving impacts how much you'll need to set aside overall. Starting early with a larger lump sum will look different than setting aside a little each month because of the impact of compound interest.
SHOULD I PRIORITIZE SAVING FOR college or saving for retirement?
Ultimately, you have to decide what your own priorities are, but one way to think about it is in terms of the future options you'll have with each scenario. Down the road, you can apply for financial aid to pay for college, but there are no financial aid packages for retirement. You may not want to support your kid’s college education only to burden them later with elder care costs.
Many experts advise taking full advantage of retirement accounts like 401(k)s before you start funding college savings, especially if you have employer matching. Assets in retirement accounts will not affect your child’s prospects for federal financial aid (unless you actually take distributions from them during the college years).
Ahhh! There's so much to consider...Just tell me what to do!
Definitely don't let analysis paralysis take over. If you're really unsure of what to do, you can reach out to a financial planner for guidance on your individual situation. Or if you're into the DIY approach, just take it step-by-step:
- Fill in any info gaps: Now that you have the basics on the different options out there, you are better equipped to do your own research to fill in the gaps and answer questions that may have come up. Check out the resources below as a starting point.
- Figure out how much you want to save: Once you've decided on which saving option or options seem to be the best fit, figure out how much your child's education will likely cost and decide what percentage of that cost you'd like to fund. There are several calculators below to help you with this.
- Figure out where to save: There are a lot of options out there, but also a lot of tools to help you make comparisons. In general, you want to make sure you're aware of fees you'll be charged, penalties you may incur and what investment options you'll have.