Now that I've convinced you to start saving for your kid's college education as soon as possible, your first question must be: Where?
You have a number of options, each with a unique set of advantages and disadvantages. Here are your best bets:
529 College Savings Plan
Pros
This state-sponsored account is available to anyone, regardless of income levels, and mostly come with high contribution limits, up to $300,000 a year. It allows your investments to grow tax-free. Withdrawals to pay for qualified educational expenses, such as college tuition, fees, room and board and textbooks are also tax-free. Plus, depending on which state plan you choose (you don't necessarily have to go with the plan from your own state of residence), you may get a state tax deduction or tax credit for your contributions.
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Cons
Unqualified withdrawals are taxed and hit with a 10% penalty fee, so you are strongly encouraged to only use the funds for the beneficiary's college education. You can, however, easily change the beneficiary to another family member, such as a sibling.
Prepaid Tuition Plan
Pros
Also state-sponsored, this type of plan lets you buy tuition at a state college or university ahead of time, allowing you to lock in today's tuition rates. If your child decides they want to head elsewhere, the funds can be applied to out-of-state or private schools.
Cons
Only about a third of states offer these plans and restrict them to state residents. Even among those few choices, several plans are closed to new investors.
Coverdell Education Savings Account (ESA)
Pros
This type of account allows your money to grow tax-free, and withdrawals for qualified educational expenses are tax-free also. The definition of qualified expenses is broader than that of a 529 plan—it includes tuition for private elementary and high school, too.
Cons
You must have a modified adjusted gross income of less than $110,000 if you're single, and $220,000 if you're married, in order to contribute to a Coverdell. And your contributions are limited to $2,000 per year. Also, unqualified withdrawals are taxed and charged a 10% penalty—as is any money not used by the time the child turns 30.
UGMA/UTMA Custodial Accounts
Pros
These types of accounts allow you to save in your child's name, which can offer some tax savings, and the funds can be used for any reason. Anyone can contribute, regardless of income, and there are no contribution limits. Full-time students under the age of 24 pay no tax on the first $1,000 of investment earnings. For the next $1,000, they pay their own tax rate—presumably a lower rate than yours. Everything else is hit with your marginal tax rate.
Cons
Since the funds in these accounts are considered assets of your child, it will adversely affect how much financial aid he or she can qualify for. That's because a larger amount would be expected to go towards education costs than if the funds had been left in the parents' name.
Roth IRA
Pros
Though its specified purpose is as a retirement savings vehicle, funds in your Roth may be used to cover college costs. Contributions to a Roth can be withdrawn at any time for any reason, tax- and penalty-free. Earnings can also be withdrawn without incurring the 10% early withdrawal penalty, if you use them to pay for qualified educational costs. If you are under age 59½, however, you still have to pay taxes on such a withdrawal.
Cons
In order to contribute to a Roth, you must have a MAGI of less than $132,000 if you're a single filer, or $194,000 for married couples who file their taxes jointly. Your contribution limit is $5,500 in 2016. Also, let me point out again, this money is typically saved for the purpose of funding your retirement—and that should take priority over paying for your child's education. Do not sacrifice your retirement savings.
Which of these options would be best for you? Most people likely will find that a 529 is their optimal choice. But it really depends on your unique financial situation. You might even want to consider some combination of the aforementioned accounts.
You should consider many factors when making this decision. Some questions you might ask yourself include:
- What is your tax filing status and your annual gross income?
- How many children do you have, and how old are they?
- How old will you be when your eldest child starts going to college?
- How much do you plan to contribute to your kids’ college savings?
- How much control would you like to have over your investments?
- How likely is it your savings will be used to pay for college?
Answering these questions can help you narrow down the right account for you. Working with a financial adviser can help ensure that you pick the right type of account or combination of accounts to maximize your tax advantages, growth potential and the likeliness that you'll be able to achieve this important financial goal.
Scott Vance is a fee-only financial planner and enrolled agent serving the greater Raleigh, NC area. He recently retired from the Army and seeks to continue service through financial advising.
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