Starting early with college savings is a smart choice. With the price of higher education rising each year, the sooner you start, the better chance you’ll have of helping make a dent in those costs. The average private college charged $45,370 for tuition, fees, room and board in 2017, according to the College Board. That’s a hefty amount for just one year. Multiply that by four for an undergrad degree, and you can see the impact college can have on finances.
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Even if children are not on the horizon yet, you’ll want to know your savings options. After all, failing to plan is planning to fail. And with your child’s educational expense burden on the line, you’ll want to be certain you’re making the best choices for their future.
What Is a 529 Plan?
One of the most popular choices for college savings is a qualified tuition program (QTP), commonly known as the 529 plan. This tax-advantaged college savings plan is sponsored by states, state agencies or educational institutions. A 529 plan has some of the highest contribution limits available for tax-advantaged accounts. Almost all states offer plans with limits as high as $300,000 to $400,000.
There are two types of plans under the 529 umbrella:
529 College Savings Plan
A 529 college savings plan account allows you to contribute funds (up to state maximums) that can grow tax-deferred, in various investments. If your state taxes income, you can usually deduct 529 plan contributions. However, there are limits to how much you can deduct. Furthermore, there are gift tax limits to keep in mind. You’ll want to check with a tax advisor if you plan to contribute a large amount of money in a single year.
At any time, the account owner is allowed to withdraw money for qualified educational expenses, tax-free. However, income tax and a 10% penalty tax is applicable if the money’s used for other purposes. Because this is a tax-advantaged account, the government levies penalty taxes if you don’t use it for the intended purpose: education.
You can find state-sponsored programs as well as purchase plans through a broker. Each plan usually has a variety of investments to choose from including stocks and bonds as well as additional options.
529 Prepaid Tuition Plan
A prepaid college tuition savings plan will let you lock in tuition prices at eligible public and private colleges. Instead of investing in a portfolio, you essentially buy a portion of educational costs ahead of time. This means your money is guaranteed, unlike a college savings plan where your investments might lose value if the market fluctuates. Depending on what’s offered by your state or educational institution, you’ll choose either a contract, unit or voucher plan. State residency is usually a requirement for prepaid tuition plan.
The beneficiary usually isn’t required to use the money for an in-state school, but the plan is designed for in-state prices so you may have to pay the difference for an out-of-state school. Most prepaid tuition plans allow tuition and fee expenses only. However, some plans will allow you to purchase a room and board option. One last difference between a college savings plan and prepaid tuition is that there’s a set enrollment period each year for the prepaid tuition plan. College savings plans are usually open enrollment year-round.
What Is a UGMA/UTMA Account?
If you want to establish a custodial account for a minor without creating a trust, you have options. The Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) is a way for minors to receive gifts such as money or property. It’s an account you hold for your child (or any minor) until he or she reaches 18, 21 or 25 (depending on the state and account type). At that time, he or she will assume control of the account and can use funds as needed.
You can contribute as much or as little as you want to a UGMA/UTMA, but keep in mind you may have to pay taxes. Contributions up to $14,000 are excluded from gift tax. Another tax concern is that this type of account is not tax-deductible nor is it tax-deferred. You may have to pay child tax or claim it on your own tax return. For more information on filing thresholds, consult your tax advisor, or IRS topic 553, known as “kiddie tax.”
While this is an option for your child’s college savings plan, it’s not the most advantageous in regards to financial aid. All assets in the account are considered the student’s. This can affect the amount of financial aid the student qualifies for.
What Is a Coverdell Education Savings Account?
A Coverdell Education Savings Account (ESA) is a tax-deferred custodial education savings account with an annual contribution limit of $2,000. The first qualifier for this college savings plan is that you can only establish a Coverdell ESA if your modified adjusted gross income is less than $110,000 for single filers or $220,000 for joint filers.
The next thing to know is that you can only contribute a combined $2,000 a year per designated beneficiary. That means if your child has more than one Coverdell ESA (perhaps a relative opened one as well), you’ll have to coordinate to ensure you don’t exceed $2,000 a year.
You can add money to the ESA until the beneficiary reaches age 18. After that, you can’t add funds, but the account stays open. Beneficiaries have until 30 days after turning 30 to withdraw funds. The money can be used for any qualified educational expenses related to college or even elementary and secondary school. Qualified expenses include tuition and fees, books, supplies, and room and board. The full list of qualified expenses can be found on the IRS Coverdell web page.
If you’re interested in opening a Coverdell ESA, check your current bank to see if it’s an offered product. If it isn’t, most large banks will have this type of custodial account as a savings option. Usually, you can choose between certificates of deposit, mutual funds and other investment options for the account.
Curious about taxes? The biggest advantage is that the earnings will grow tax-free. However, your contributions aren’t tax-deductible. Generally, you won’t pay income tax for withdrawing funds for qualified expenses. However, this can vary by state and depends on how you file your taxes. You’ll want to check with a qualified tax professional or your accountant for a concrete answer.
Whichever path you choose to go, remember that saving early and often will give your money the best chance to grow. With tax-deferred or tax-advantaged accounts, you can’t go wrong saving for your child’s future education. And remember, you can open more than one type of account. You’re not limited to one college savings plan.
Tips for Maximizing Your Savings
- You might be losing out if your money is in a low interest savings account. Compare your interest rate to what you’d earn with a high yield savings account and see if you’re getting enough bang for your buck.
- Learn about other savings options, such as CDs, money markets and more. A savings calculator can help you see how your money can grow over time. Taking charge of how you save is one of the best things you can do for your financial future.
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