When your children are small, thinking about the future usually means remembering to put dinner in the crock pot (harder than it should be, amiright?). But as caught up in diapers and preschool as you may be, it’s important to think a bit farther down the road. Eventually, your children will learn to wipe themselves, feed and dress themselves, and someday they’ll even graduate from high school. Then comes that biggest of all big deals–moving out and continuing their education. That day may seem light years away when you’re trying to get through the day without a wardrobe change, but it will come.
That big day often comes with a hefty price tag. College tuition per year can range from approximately $10,000 to $35,000! Maybe you are able to cover the full cost of college for your children. But if not, that number can seem overwhelming. Resist the temptation to give up, save nothing, and hope your kids get a low interest rate on their student loans. Your children will not necessarily have to pay that full “sticker price” for their education. Strategies for decreasing the cost of a college education are beyond the scope of this article, but they absolutely exist. And you don’t necessarily have to cover the full cost of their college education, either. Whatever you are able to save and invest now has a double benefit; each dollar you save can earn interest now and keep your child from paying interest on a dollar later. It’s far better to be on the earning end of interest than the paying end, even if the amount is small.
Your support for your children’s education is not exclusively financial. Besides writing checks, support also includes believing in their ability to succeed, helping them strategize and plan their own finances, teaching them solid life skills, and trusting them to work hard and choose wisely. I considered my parents very supportive of my education even though their financial contribution was very small. So don’t feel guilty if you can’t pay for their education in full. Even helping college students with smaller expenses like books or groceries can decrease their financial stress and help them feel supported. Starting now and using the right tools can help you leverage what you are able to contribute.
With saving, time is your greatest asset. Investing time into planning now will give you more options in the future. Whether your child is in preschool or middle school, now is the best time to start planning and saving.
What Are My College Savings Options and Why Should I Use Them?
When saving for college, stashing cash in your regular savings account is not the best option. Holding cash in the bank for a long time will earn you ~.05% a year, which doesn’t even keep up with inflation. Luckily, special college savings accounts exist. They have tax benefits and investment options so your dollars grow while your kids do. Harnessing the power of compound interest and time will magnify your savings and give you options in the future.
College saving accounts are not investments themselves; they are “baskets” that hold actual investments, e.g. mutual funds. So you can open a college savings account, and then choose investments to purchase and store in that “basket”. Each type of college saving account has slightly different benefits and restrictions, so I’ll review and compare them. Please consider this a jumping off point to research the savings plan best for you.
The 529 College Savings Plan
Tax Rules
- Contributions are not federal tax deductible, meaning you contribute with after-tax dollars, much like a Roth IRA. Some states allow state tax deductions for contributions.
- Earnings are not taxed, meaning you don’t pay capital gains tax each year on the interest your money earns, allowing it to be reinvested and grow more effectively.
- Withdrawals are not taxed, as long as they are used for qualifying educational expenses.
Contribution Limits
- The IRS has not specified a dollar limit for the 529 plan, but anything over $15,000 will exceed the gift tax exemption. (Read more about gift tax here and here.)
- Contributions cannot exceed the expected cost of education for the beneficiary. That number varies by state, but most are high enough that you shouldn’t have to worry about it.
Withdrawal Limits
- Withdrawals are tax free when used for qualified educational expenses.
- Qualified educational expenses include tuition at vocational and trade schools, secondary education, and post-secondary education.
- Withdrawals may also be used for tuition, books, room and board, fees, and computers and technology.
- Up to $10,000 per year may be used to pay tuition for private or public elementary or high school tuition.
- Withdrawals used for non-qualified expenses are subject to taxes and penalty, although only on the earnings portion. You’ll never pay taxes on the principal you contributed because you used after-tax dollars.
General Facts
- 529 plans are sponsored by states and some universities. You are not restricted to the 529 plan sponsored by your state.
- Each 529 plan has a designated beneficiary. This can be a child, grandchild, spouse, yourself, or other family member. The beneficiary uses the funds but does not control them.
- Plan beneficiaries can be changed, and 529 funds can be rolled into different 529 accounts without tax or penalty.
- Assets held in 529 plans are considered when applying for FAFSA, but the exact implications vary depending on the amount in the account and who owns it. Read more about it here.
Coverdell Education Savings Accounts (ESA)
Tax Rules
- Contributions are not federal tax deductible, meaning you contribute with after-tax dollars, much like a Roth IRA.
- Earnings are not taxed, meaning you don’t pay capital gains tax each year on the interest your money earns, allowing it to be reinvested and grow more effectively.
- Withdrawals are not taxed, as long as they are used for qualifying educational expenses.
Contribution Limits
- The IRS limits contributions to $2,000 per year per beneficiary.
- There is no limit on the number of ESAs you can open, but the combined contributions to all cannot exceed $2,000/year per beneficiary.
- Contributions must be made while the beneficiary is under age 18, or qualifies for special needs age exceptions.
- Unlike the 529, ESAs are phased out in higher income brackets. If your adjusted gross income exceeds $190,000 for married filing jointly or $95,000 filing singly, you are ineligible to open an ESA.
Withdrawal Limits
- Withdrawals are not taxed, as long as they are used for qualifying educational expenses.
- Withdrawals may be used for K-12 expenses for public and private schools.
- The account must be completely drawn down (used up) by the time the beneficiary turns 30, or the remainder will be withdrawn within 30 days and the earnings will be subject to tax and a 10% penalty.
General Facts
- The account beneficiary may be changed without tax or penalty as long as the new beneficiary is under 30.
- While some 529 contributions can be refunded to the parent or custodian of the account under certain circumstances, ESA contributions all go to the beneficiary.
Uniform Gifts to Minors Act and Uniform Transfers to Minors Act (UGMA and UTMA)
Tax Rules
- As this account is not an education-specific account, earnings are subject to some taxes. A certain amount of earnings will go untaxed, then a portion will be taxed at the child’s rate, and any amount above that will be taxed at the parents’ marginal tax bracket. Read more about it here.
Contribution Limits
- There are no contribution limits, but large contributions are subject to gift tax.
- Contributions may be used to purchase standard investments but none considered high risk (like stock options).
Withdrawal Limits
- Withdrawals do NOT have to be made for qualifying educational expenses.
- The custodian of the account may make withdrawals on behalf of the child for any expense for the benefit of the child (medical expenses, pre-college education, etc.).
- The account is considered property of the child, and account control is transferred to the child when he/she reaches the age of majority (usually 18, sometimes 21 or 25).
General Facts
- The UGMA/UTMA funds are an asset of the child and are considered when applying for FAFSA. They may reduce the amount of financial aid by 20%.
- There is no ability to transfer the account to another child or adult.
Which One Should I Choose?
That’s the question I can’t answer for you. It depends on your situation. Do your research carefully, and choose investments wisely. Opening accounts and choosing investments can feel intimidating, but knowledge will give you confidence to move forward. Begin researching the type of account that seems right for you, and then take baby steps forward. Even saving $20, $50, or $100 a month towards education can add up in the end.
Saving and investing for the future is an important task that deserves your attention. My husband and I like to schedule a monthly “Money Party” where we set aside an hour to give attention to our long-term financial goals. We have dessert while we talk so the meeting isn’t a chore and doesn’t get procrastinated. It helps us counsel together on big decisions and then take action. Once we decided to open a college savings account for our daughter, it only took 30 minutes to actually open the account, transfer money, and select index funds to purchase. I know you can do it too! Start where you need to, and move forward with the end in mind.
How Much to Save for College
There are obviously several variables that will determine how much you should try to save for your child’s education. Public or private university, living at home or on campus, 2 or 4-year school, location, area of study, and many other factors come into play. However, for a great guide on gauging where you are currently and how much you need to continue saving monthly, check out this excellent college savings calculator.
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