One thought that many young parents ponder on is how to pay for their kids' college education. A four year price tag for college can easily total over $100,000. Large amounts of college debt can hinder graduates’ ability to buy homes and save for retirement. So where is the best place to save?
When you begin saving for college it is important to understand how the accounts you are investing in will be taxed, as well as how each account affects your child’s ability to get financial aid. Below is a short list of ways to save for college education.
1. Custodial account
A custodial account doesn't necessarily offer any tax benefits, and could be taxes at the parent’s income level once the account reaches an income above $2100 a year. Custodial accounts are considered an asset of the student on the FAFSA and are counted at 20%.
2. 529 Plans
A 529 plan provides some tax benefits on the gains of in the account. As long as distributions are taken for qualified education expenses there are no penalties, and no taxes to be paid. You can contribute up to $14,000 annually, or you can "max fund” a 529 plan by putting in a lump sum of $70,000 (considered five years of contributions). After the five years are up you can resume contributions.
You can change beneficiaries on 529 plans.
Many states offer a state income tax deduction for contributions to their 529 plans.
Assets in 529 plans are considered an asset of the parent on the FAFSA (counted at 5.64%).
Coverdell plans are very similar to 529 plans when it comes to taxes, withdrawals, and beneficiaries. One big difference between the two is that the maximum amount a person can contribute to a Coverdell is $2,000 per person per year. There is also an income limit for eligibility, whereas 529s have no income limitation.
You can also make withdrawals from a Coverdell for grade school through high school tuition. This could be a benefit if you know that your kids will be attending a private school AND you have the income to fund it very early.
Coverdell assets are counted the same as 529 plans for financial aid.
4. Roth IRAs
People who are not maxing out their contributions to Roth IRAs may want to consider funding a Roth for college before starting an education account. A Roth has a maximum contribution limit per person of $5,500 for individuals under 50, and $6,500 for persons 50 and older. Roth IRAs grow income tax free, and can be used for education as well as retirement.
If you choose to use a Roth IRA to fund your children’s education, I would recommend setting up a separate Roth IRA designated solely for education. Setting up a different account will keep the education funds separate from your retirement funds.
Roth IRAs are not counted on the FAFSA, therefore they can be a great option for college savings. Does your child have any earned income? If so, he/she can contribute to a Roth IRA.
5. Traditional IRAs
Traditional IRAs are rarely used for education, but it is possible. Withdrawals can be made from traditional IRAs with no penalty for qualifying education expenses. One benefit to IRAs is that they are not counted on the FAFSA.
A word of caution
Please make sure you fully understand what you are doing before withdrawing funds from a retirement account for your kid's education. While it is feasible and can be a benefit, you need to make sure you are not robbing your retirement for college funding.
Not a good college funding tool
Life insurance! There are many salesman that hold themselves out as college funding experts that are really pushing life insurance. They will make it sound like the best thing since sliced bread without telling you any of the drawbacks. So PLEASE don’t look at life insurance as a college savings tool.
Save with the end in mind
Knowing how different accounts are considered for financial aid should affect the way you invest today. If you have $100,000 saved in a custodial account versus $100,000 saved in a Roth IRA for college, your EFC (expected family contribution) could be $20,000 more just in the first year of college! In other words, where you have invested is a big deal when you are applying for financial aid.
Regardless of the method you use to save for your kid's college, it’s best to start early. The earlier you start, the more time you have for your money to grow, and with the rising costs of college you need those dollars to grow! Ideally, you will want to save in the most efficient way possible so that you don't disqualify your student from receiving financial aid. If you want to have a discussion about college planning, and see how we can help you are welcome to email me.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.