A relatively common question asked by parents is how early should they begin savings for a child’s college education. There is no right or wrong answer as any contribution you make towards your child’s education will help them greatly. However, if you want to front the majority or full cost of university, then the sooner you start saving, the better.
Let’s ruminate on this. By starting to invest and save for college the day the child is born, the longer the period of time the money has to compound and grow. So although this topic probably isn’t the first thing to come to mind the day your baby is born, there’s good reason why it should be. It would also never hurt to start saving prior to any child being born. Nevertheless, if you haven’t started saving yet, don’t feel too discouraged. It’s never too late to start.
Below are 9 outlined different ways to save for a child’s education and some need to know information about each. Please keep in mind that this is not a one-size-fits-all type of savings activity and that the best option for each individual might be different based upon their circumstances. Also, I would highly recommend speaking with your tax professional prior to implementing any of the strategies below. That being said, let’s begin.
#1 & #2. 529 Plans
Named after section 529 of the Internal Revenue Code, this is also known as a qualified tuition plan (QTP) which can be started through a state or through a custodian. There are two types of 529 plans:
#1. College Saving Plans
Allow you to invest your after tax contributions and grow tax free. Investments differ by plan however most have a normal variety of investment options. This is the most common type of 529 plan that you will hear people talk about. There is the obvious downsides of your child potentially not wanting to go to college and poor performance of investments. But these are risks you can mitigate by educating yourself and making smart choices. With these plans, you are limited to the investment options in the plan that you chose, however there are enough 529 plans out there to choose from that you will definitely be able to find one that has an investment profile you want.
#2. Prepaid Tuition Plans
Allow you to pre-pay all of or part of tuition costs of an instate or private education. This locks in tuition at the current rate it is at. Downside is the lack of options this provides the child however do your due diligence to see if you state allows the transfer of funds, as some do.
Everything you need to know about 529 plan contributions:
Contributions to a 529 plan grow tax free. Withdrawals are also tax free if used for qualified education expenses. Qualified education expenses include tuition, books, equipment, etc. For more information on qualified expenses, visit this page.
Contributions are considered gifts for tax purposes which means the annual contribution limit will always match the annual gift tax exclusion, which is currently at $15,000 per individual (you and your spouse can each contribute $15,000 so total contributions would be $30,000).
There is also the 5 year election rule which allows the contributor to put up to $75,000 (5 years of the $15k gift tax exclusion) into the account in one year if they treat this contribution as if it was spread across the 5 years.
Plans differ by maximum limits allowed in the account so make sure to clarify this when you are opening the account (ranges rom ~$200k – $500k).
You can contribute to both a Coverdell and 529 plan in the same year for the same beneficiary.
Other important things to know about 529 plans:
It is important to note that QTP contributions are not deductible federally but some states give you a credit or deduction for your tax return, so be sure to double check prior to opening. You can utilize any states 529 plan, not just the state you live in and plans differ from state to state.
Anyone can open an account for a designated beneficiary, it does not have to be a parent. Also, anyone can contribute to a pre-existing plan.
A way to mitigate the “child doesn’t want to go to school” risk is transferring beneficiaries. The designated beneficiary on the account can be changed as needed. Another case when this may be useful is if you have more than one child and the first child did not need the full amount of their 529 plan, so you make the beneficiary whoever is next in line for their degree.
These plans also let you withdraw up to $10,000 a year and can be used towards qualified K-12 schools.
The beneficiary doesn’t have to include the earnings from a QTP as income distributions, these aren’t taxable if used to pay for qualified education expenses
The FAFSA valuation process does include this in the expected family contribution (EFC) amount. For parents of the child, FAFSA counts a max of 5.64% of assets towards this evaluation. Learn more about FAFSA need based aid and EFC here.
A solid strategy if you plan to implement a 529 plan would be to ensure that it is in the parents names and not the grandparents because when distributions come around, if it is in the grandparents name then the distribution will be considered income to the grandchild and up to 50% of student income is assessed for the EFC. For example, a grandparent opens an account and distributes $10,000 to the child for college, that means the child will now receive $5,000 less in aid.
Important to note that an American Opportunity Credit or Lifetime Learning Credit can be claimed in the same year the beneficiary takes a tax free distribution from a 529 plan.
Click here to visit an IRS publication that contains more info on these plans.
#3. Coverdell
Another well known type of education savings account (ESA) is referred to as a Coverdell ESA, formerly known as an Education IRA. These accounts have the benefit of tax free earnings growth and tax free withdrawals when funds are spent on qualified education expenses. Coverdell accounts can be invested in stocks, CDs, mutual funds, etc.
Coverdell ESA Contribution Info:
A Coverdell allows you to contribute up to $2,000 per designated beneficiary. That is total amount across all Coverdell accounts, so if Grandma opened one as well the parents, they must be careful to not contribute more than $2,000 total.
That being said, there is no limit on the number of accounts that are set up for the same beneficiary.
Contributions must be made prior to the beneficiary turning 18 years old otherwise contributions can face a 6% excise tax.
The income limitations state that for taxpayers claiming as single, Modified Adjusted Gross Income (MAGI) of $95,000 or less can contribute the full $2,000 to the account, for joint filers a MAGI of $190,000 or less allows the full contribution amount. For single filers with incomes between $95,000 and $110,000 a partial contribution can be made to the account, and for joint filers between $190,000 and $220,000 a partial contribution can be made. For single filers with MAGI over $110,000 and joint filers with MAGI over $220,000 no contribution is allowed.
Other information about Coverdell ESAs:
The designated beneficiary can be changed but unlike the 529 plans that allow you to change to non-family members, a Coverdell will only allow beneficiary changes if the beneficiary is within the same family. This again, could be beneficial if child #1 finishes school and there is still money left over in the account to go to child #2.
These funds can also be used for qualified K-12 education expenses.
All funds must be withdrawn by the time the beneficiary reaches the age of 30 otherwise the remaining funds will face penalty charges of 10% and federal income tax. If the child hasn’t started school by 18 and you are worried about the 30 age limit on Coverdell accounts, you can always roll over these accounts into a 529 plan for the beneficiary.
Corporations and trusts can also contribute to these accounts.
Keep in mind how these accounts are affecting your child’s FAFSA estimated family contribution (EFC). If kept in the parents name, up to 5.64% of the accounts value will be factored into EFC. If kept in a grandparents name, the withdrawals can count up to 50% towards EFC since these withdrawals will be considered the students income.
#4. UTMA/UGMA
UTMA (Uniform Transfer to Minors Act) and UGMA (Uniform Gift to Minors Act) have been in the college savings realm for quite some time. These are custodial accounts that hold and protect assets for minors until majority age. Majority age can vary by state, but for the most part it is 18 years old. So the parent has control over the account until the child hits the specified age, then it becomes the child’s investment account.
While some states allow UTMAs and others allow UGMAs, they are virtually the same. The only major differences are within the assets being contributed to them.
Contributions:
UTMA accounts allow for contributions of any asset including real estate.
UGMA accounts are limited to cash, stocks, bonds, mutual funds and insurance policies.
Both types of accounts are funded by after tax money like 529 plans and Coverdell ESAs.
There are no yearly contribution limits to these accounts. But if you are contributing more than the annual gift tax exclusion then be aware that this would affect your lifetime estate tax exclusion.
Other information:
Anyone can transfer assets into an UTMA or UGMA account for a designated beneficiary.
Unlike a Coverdell account or 529 plan, withdrawals from the account do not need to be for qualified education expenses. That means the money in this account could be used for a house, marriage, to start a business, etc.
The recent tax reform restructured how these accounts are taxed. The new trust taxes on capital gains and qualified dividends are:
$0-2,599 = 0%
$2,600-$12,699 = 15%
$12,700 and over = 20%
The new trust tax brackets and rates on ordinary income are as follows:
$0-$2,550 = 10%
$2,552-$9,150 = 24%
$9,151-$12,500 = 35%
Over $12,500 = 37%
When the child hits the majority age, the asset is theirs. That means they can use it on what they want. This also means that this account will be counted as the child’s asset for FAFSA.
These accounts do not let you change beneficiaries or transfer the account to another child and any unused funds must be distributed by the time the child reached the age of majority (some plans allow for an older age than 18).
The American Opportunity and Lifetime Learning Credits can be used in combination with these accounts.
#5. Roth IRA
This is an underrated option for college savings. Now this is directed towards opening a Roth IRA for the child however if you want to use your pre-existing Roth IRA it is important to know that distributions before age 59.5 will not face the 10% tax if used for qualified education expenses or if distribution equals or is less than the total contributed amount to the Roth IRA. Also, the account must have been established at least 5 years prior to the first withdrawal. Traditional IRAs are subject to federal and state tax.
Contributions:
That being said, you can open up a Roth IRA for your child if the child is making money. The Roth IRA can be funded up to $6,000 if the child earned that or more in the said year. That means if your baby is 2 years old and getting paid to model for Gerber, you can put money away in their Roth IRA.
Roth IRA’s allow tax free growth of funds invested and also tax free withdrawals for qualified education expenses. These accounts can be set up at a custodian and then you invest them into the market based upon your goals.
There are also income limits for investing in these. For a single filer, if you earn less than $122,000 then you can contribute the full amount, if you earn $122,00 or more then you can contribute partial amounts and if you earn $137,000 then you are not allowed to contribute.
For joint filers, if combine you earn less than $193,000 then you can contribute the full amount. If combined you earn $193,000 or more you can contribute partial amounts and if you earn $203,000 combined you are not eligible to contribute to these accounts.
Other information:
Roth IRA’s are flexible in the sense that you can always withdraw up to the total amount you have contributed at any time without facing a tax or penalty.
If the child decides not to go to school, this account can be used towards retirement still and up to $10k of the funds contributed can be used for their first home purchase.
Not to mention the added benefit of teaching your child about the market and showing them how to invest from a young age.
Since these are considered retirement accounts, the asset will not be accounted for during the FAFSA EFC evaluation. Therefore, it makes the need based financial aid higher for the child. However, since these withdrawals to pay for qualified education expenses will count as income for the student, that withdrawal amount will affect future FAFSA need.
#6. Brokerage Account
This is pretty self explanatory but say you want full control over the account and investments, then this might be the best fit for you. No, there are not education benefits for this account, meaning distributions for qualified education expenses and tax free growth are not an option, but you are completely and entirely in charge of the account and investments within it.
A brokerage account can be opened for a minor and you can also let them do the investing. To open the account you will need an adult or co-signer of some sort.
Although I personally would not use this as a way to save for education, I have heard of people in the FI (financial independence) community doing this to keep all of their investments bundled together for maximum growth .
#7: Education Bond Savings Program
Another option that could pay for partial amounts or full education expenses is cashing in bonds for qualified education expenses. If you do so, you do not have to include the income from bonds in your income for tax purposes.
Bonds allowed in this program include series EE bond issued after 1989 or a series I bond.
Again, I personally do not foresee myself buying bonds to help supplement the cost of a child’s education but in some cases this could make sense. Or if the parent already has a lot of bonds and doesn’t want to increase their taxable income, this would be a great option or them if they did not need the income from the bonds.
#8. Savings Account
A savings account provides safety for those who are not comfortable investing their money in the market and are very skeptical about investing in general.
Although you do not get the tax benefits of an education savings plan, this option would give you complete control over your money. It is also important to note that if you don’t hedge against inflation, your money could end up be worth far less in the long run.
To try to hedge against the impact of inflation you could invest in a money market account, CD or even bonds (check out TIPs or treasury inflation-protected bonds) to minimize the risk of inflation). And as mentioned above in #7, cashing out bonds for qualified education expenses and your taxable income wont increase.
Again, this would never be my first choice to save for education because of the potential inflation downfall, however, for those who have no comfort in investing in the market – this may be one of your only options where you feel safe.
#9. Real Estate
Now I have to admit, I had never heard of this strategy for college savings until Brandon Turner, from BiggerPockets mentioned that he did this for his daughter, Rosie. See, Brandon bought a 4 family home and put it in Rosie’s name the day she was born. As Rosie ages she will learn the ins and outs of long term rental real estate by working with her dad on managing the property AND she will own a home outright.
Yup, that’s right. At 18, the 4 family will be completely paid off because Brandon is structuring his payments that way. He found a deal where the monthly rents can pay for the mortgage each month and so that the loan can be paid off in 18 years. This is an extraordinary strategy if you are real estate savvy and have some extra money lying around or are willing to get creative with funding.
Yes, you will either need to have the money for the down payment on the home or you will have to be able to get creative with financing this. But it is still a great option.
The benefit of the home being completely paid off by the time his daughter will be going to school is that she will have the choice of selling the home (however this will still mean she has to pay selling costs and any capital gains tax), pocketing the monthly cash flow (since the loan will be paid off – all rent payments are hers and therefore could be used to pay for college expenses) or refinancing to pull cash out to pay for school.
This is a great option especially if you want your kids to learn more about real estate, managing money and feel involved since its in their name.
No, this does not get the tax benefits for qualified education expenses but you do get the benefit of using the money from this towards any sort of expenses and not to mention the incredible tax advantages of owning real estate. So if the child decides college isn’t for them, they have a stream of income to try to start a business or buy more real estate with.
You could also combine this strategy with the Roth IRA strategy, by having your child work at the property or even at other properties you own. And instead of paying them by putting money into their bank account, you could put money into a Roth IRA for them. By doing this you would be setting them up for the future.
This is definitely a strategy I will be utilizing with my future children to teach them the value of hard earned money and also how to invest in real estate.
Bonus Information to Consider
Credit of $2500 a year for qualified education expenses.
100% of the first $2000 of qualified education expenses you paid for each eligible student and 25% of the next $2000 of qualified education expenses. If credit pays your tax down to zero, you can get 40% of the remaining amount of credit (up to $1000) refunded to you. Click the title for more information on claiming and eligibility.
For qualified tuition and related expenses paid for eligible students enrolled in an eligible educational institution. This credit can help pay for undergraduate, graduate and professional degree courses including courses to acquire or improve job skills. There is no limit on the number of years you can claim the credit. It is worth up to $2000 per tax return. Click the title for more information on claiming, income limits and eligibility.
Conclusion
The 9 strategies listed above can be used on their own or in combination to lessen the burden of attending college. There is no right or wrong way to save for college and there is no right or wrong amount either. Anything you can save to help diminish the price tag on higher education will help your child immensely. Lastly, please be sure to talk with your tax professional prior to implementing any of the above strategies to see which makes the most sense for your current situation.
Let us know how your saving for college in the comment section!
Thanks for sticking around ’til the end 🙂
