The “saving for college” discussion is one I have with clients nearly every day. Since the topic comes up so often, I thought it would be beneficial to share a few recommendations on a greater scale.
Here are 5 ways you can start saving for your child’s college education today:
1. College Savings Plans (529)
529 plans are tax deferred, much like an IRA, and the distributions can be used to pay for “qualified education expenses” (QEE), which can be withdrawn tax-free. For example, if you put $1,000 into the account, and over the course of several years it blossomed to $3,000, the interest earned ($2,000 in this case) could be removed under the QEE, tax free. The QEE includes more than just tuition and fees; it can also include books and supplies. In 529s, you select investments (e.g., a balanced fund) to encourage account growth. This account allows you to contribute up to $14,000 per year to a college savings plan or contribute up to 5 years of contributions at once ($70,000). If you are very conservative in nature, this account choice may not be ideal for you/your family (a pre-paid tuition plan may be a better fit – see #3 below).
2. UTMA (Uniformed Transfer to Minors Act)/UGMA (Uniformed Gift to Minors Act) Accounts
In this option, each parent may contribute up to $14,000 per year to each child without concerns regarding gift tax issues. The account is owned by the child and when they reach the “age of majority,” the account gets transferred into the child’s name. This can be risky if the child thinks purchasing a new BMW is a better use of this money vs. paying their college tuition. A benefit of UTMA/UGMA is that the transfer is an irrevocable gift to the child and the donor is reducing the size of their estate with each contribution. Another great advantage of these accounts is the ability to invest in almost anything. The downside to UTMA’s is that there is no real tax benefit when gifting the money to your children, and any investment income greater than $1,900 may be taxed on the parents’ return until the child is 18.
3. Prepaid Tuition Plans
A prepaid tuition plan is a form of the 529 plan. This option allows you to purchase units of tuition of a specified school at today’s prices. This locks in the cost of tuition at today’s rate. In most states, you may transfer prepaid tuition to a college savings plan. Prepaid tuition plans are great if you are sure that your child will attend an in-state public school. They are not so great if your child decides to attend a private or out- of- state school, as you will receive the “average” in-state tuition exchange rate.
4. Coverdell Education Savings Accounts (ESAs)
Coverdell ESAs can be used for all years of education, not just college. Contributions are limited to $2,000 a year, and when withdrawn for “qualified education expenses,” should be tax-free. Contributions can only be made for a child who is under 18, and you can invest the money as you see fit. The catch with this plan is that the money must be withdrawn from the account once the child reaches age 30.
5. Other Options – Current Cash Flow and Loans
This option is not a tried-and-true way to save for college, but it is a strong option if you did not plan to send your child to college and are looking to assist them. With this option, you can pay the cost of tuition from discretionary cash flow or from various loans. While the most common is the student loan, another option is a home equity line of credit (HELOC). This way the parent, or even grandparent, can help the child through school with a modest interest rate that sometimes can be deducted on their tax return.
My general rule for college planning is to save half of the college tuition before the child turns 18. This way, the remainder can be covered from discretionary income or student loans. It never hurts to consider letting your child bear some of the burden by having them take out a loan (e.g., Stafford Loan), or even to seek out opportunities to work and contribute to the cost of their own education.
When it comes to saving for college, there isn’t a one-size fits all approach. We recommend you review www.savingforcollege.com to learn more about available options, and discuss with your financial adviser which option might be best for you and your family.
And remember, it’s never too late to start saving.