If you’re a parent hopeful of one day seeing your toddler in college, you should seriously consider starting a savings plan to help them with their future expenses – right now.
Collegedata.com, reports that a “moderate” college budget for an in-state public college for the 2016–2017 academic year averaged $24,610 and a moderate budget at a private college averaged $49,320. If you plan on sending your son or daughter to a premier college such as Cal-Berkeley or Harvard, you will most likely pay more. And this cost will only continue to increase in the years ahead – with SavingforCollege.com projecting tuition inflation at a rate of 5% annually.
What’s the best way to save and how much? In Bankrate.com’s “College Savings Plans and Other Good Accounts for Saving for Your Kids,” author Christina Couch explains the primary plans to save for college, starting with the popular “529 college savings plans” that come in two forms – standard and prepaid.
The Standard 529 Plans
Offered by financial institutions and/or universities in all 50 states, a 529 college savings plan (named after Section 529 of the IRS Code) is a tax-advantage account that allows parents to save as much as they want for a child’s education, tax-free. Money in these accounts can be used for undergraduate or graduate studies at any accredited two- or four-year school in the U.S.
Comparable to a 401(k) or IRA, a 529 account can be funded through a variety of investment options. There are no income or other restrictions on contributing to a 529 plan and these plans offer significant tax advantages. For example, the earnings are tax-deferred and, once the funds are used to pay for qualified tuition expenses, parents will not pay any taxes on those funds.
An important feature of 529 plans is that the saving account belongs to the parent, not the child; the account is considered the parents’ asset and they can change the beneficiary whenever they want. According to Kelly Campbell, a certified financial planner and founder of Campbell Wealth Management, if the child says he or she doesn’t want to go to college, the parents can transfer the funds to another sibling. “That way, you know the money will be used for education,” notes Campbell in “Allocating Assets Based on Your Child’s Age.”
According to the IRS, 529 earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses, such as tuition, fees, books, as well as room and board. Contributions to a 529 plan, however, are not deductible.
Prepaid tuition plans
Another way parents can save for a child’s college expenses is a prepaid 529 tuition plan, which may appeal to parents who are certain their son or daughter will attend a public college in their own state. This plan allows parents to pre-pay for tuition in advance of the child attending college based on the school’s fees at the time the account is opened.
Savingforcollege.com points out that while it’s true that a prepaid plan is designed to “lock-in” the tuition of public colleges and universities in states offering the plan, that does not preclude your child from using prepaid plan benefits toward tuition to attend a private or out-of-state college – but there is a drawback.
“The major limitation to a prepaid plan is that if the child decides to go to school out of state, they’ll get a return on the savings, but they won’t get the full value of the plan” if the child had gone to a public state school, explains Craig Parkin, a managing director at TIAA-CREF, an investment organization that administers state-sponsored college savings plans.
Check with your local credit union or other financial institutions on the rules in your state for using the prepaid plan funding at a private or out-of-state college.
Roth IRA and Coverdell Education Savings Account (ESA)
The Roth IRA is a savings account that provides optimum flexibility and special tax treatments. Among other benefits, the account owner can withdraw funds from the principal portion of the savings (i.e., the amount of funds deposited in the account) at any time, tax-free, for educational expenses. When the owner (such as a parent) turns 59 1/2 the interest earnings can be withdrawn along with remaining principal, tax-free.
However, there are exceptions to this rule that allow for early withdrawals due to certain circumstances (hardships such as a disability) or for specific types of spending (such as purchasing a first home).
A Coverdell Education Savings Account (ESA) works in some of the same ways as a Roth IRA. They both allow you to make an annual non-deductible contribution to a specially designated investment trust account. Your account grows without accruing federal income taxes, and if all goes well, withdrawals from the account for college expenses will be completely tax-free as well.
An ESA is somewhat different in that it’s an attractive college savings vehicle for families that want to save for college as well as certain K-12 expenses. In other words, if your child attends a private high school, you can use funds from a Coverdell ESA to help with that sometime hefty tuition.
Credit Union Savings Plans
The dominant college savings program at credit unions is the 529 plan, but other plans such as Coverdell are also offered. Whether you open a savings plan sponsored by your local credit union or other financial institutions, it’s a smart move to be fully informed about the plusses and minuses of these plans for your particular situation before making a decision.