Parents who save for their child's college education are providing them with a head start in life because their children won't have to worry about the burden of student loans and can instead focus on building a successful career.
A college education is more important than ever before. It provides students with the necessary skills and knowledge to succeed in today's competitive job market. By investing in their child's education, parents are ensuring their child will have access to the best possible opportunities and can compete with the best and brightest in their field.
Saving for college also demonstrates to children that their parents value education and are committed to their future success. This can inspire children to take their studies more seriously and put in the extra effort to achieve their goals.
Parents who commit to a college savings plan are also more likely to avoid financial stress and uncertainty in the future. With a savings plan in place, parents can avoid the need to take on debt or dip into retirement savings to pay for college tuition and the many other expenses that go along with a child attending college.
Some Ways to Save
Here is what we consider to be the best savings methods available to parents to put away money for college.
529 Plans
This plan is an education savings account that is widely used because of its federal and state tax benefits when the funds are used for qualified education expenses. Use the funds for college and earnings and withdrawals are completely tax-free.
Advantages:
- Withdrawals used for qualified higher education expenses and up to $10,000 per year in K-12 tuition are exempt from federal income and capital gains tax, and some states provide additional state tax benefits.
- Depending on the chosen plan, the maximum investment can exceed $500,000 over the account's lifespan, and deposits of up to $16,000 per year per individual are eligible for the annual gift tax exclusion.
- It is also possible to treat a contribution of up to $80,000 in one year as if it was made over five years to shield a greater sum from taxes.
- 529 plans are granted favorable financial aid treatment: accounts owned by dependent students are classified as parent assets, and no reporting is required on the FAFSA when the funds are used to pay for college.
Disadvantages:
- Earnings are subject to income tax and a 10% penalty if withdrawals are not used for qualified education expenses.
- The available investment strategies are restricted to those offered by the program.
Summary:
This is an excellent method of saving for college or supplementing other potential savings. It provides good tax incentives and offers various options to grow your overall savings.
Coverdell Education Savings Account (ESA)
Previously known as the Education IRA, the Coverdell ESA is another option for tax-free interest earnings and withdrawals for qualified educational expenses, including K-12 expenses up to $10,000 per year. Not every family can take advantage of this option, however, and it has lower maximum contributions than other college funds for children.
Advantages:
- Coverdell ESAs offer tax-free withdrawals for qualified higher education expenses and K-12 expenses (up to $10,000 per year).
- There is a broad range of investment options available, including self-directed investments.
- The value of a Coverdell ESA account is counted as a parent asset on the FAFSA, regardless of whether the parent or dependent student owns it.
Disadvantages:
- The maximum investment allowed is $2,000 per beneficiary per year, from all sources combined.
- Only married couples earning less than $220,000 or individuals earning less than $110,000 can contribute.
Summary:
The Coverdell ESA is a good option for long-term savers who do not need to save a large amount for college.
Custodial accounts
Accounts established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) are brokerage accounts opened by an adult on behalf of a child.
These accounts can be diversely invested in stocks, bonds, mutual funds, and other securities, and are typically held by a parent or guardian until the child reaches the age of majority, which can be 18, 21, or 25 depending on the state.
Advantages:
- Funds saved in a custodial account can be used for any expenses that benefit the minor, such as purchasing a car, airline tickets, or a computer.
- There is no limit to how much can be invested in the account.
- The value of the account is not included in the donor's estate for tax purposes.
Disadvantages:
- Earnings and gains in the account are subject to taxation, and minors may be subject to the "kiddie tax," which applies to unearned income of more than $2,300 for certain children up to age 23, and is taxed at the marginal rate applicable to trusts and estates (as of 2022).
- Once the child reaches legal age, they will gain control of the account and may use the funds for any purpose, which may not align with the original intentions of the parent or guardian who established the account.
- Custodial accounts are considered student assets on the Free Application for Federal Student Aid (FAFSA), which can reduce a student's eligibility for financial aid by up to 20% of the account's value.
Summary:
Custodial accounts can be a useful tool for parents or guardians who want to save for a child's future expenses, such as college or other needs, and for minors who may require additional funds beyond their usual expenses.
However, it is important to carefully consider the potential tax implications, the child's level of control over the account, and the impact on financial aid eligibility before opening a custodial account.
Savings Bonds
Qualified U.S. Savings Bonds are an old-school approach to college saving but are a secure investment option because savings bonds are debt securities issued by the Department of Treasury and backed by the U.S. government.
Although the return on an investment is modest by most standards, investors can be assured of one thing – the safety of their money.
Advantages:
- U.S. savings bonds are federally tax-deferred and exempt from state taxes.
- Series EE and I bonds purchased after 1989 may be redeemed tax-free at the federal level for qualifying higher education expenses, making it a beneficial way to save for a child's college education.
- Bondholders invest in interest-earning bonds with the full faith and credit of the U.S. government.
Disadvantages:
- The maximum annual investment limit is $10,000 ($20,000 for married couples) per type of bond and per owner.
- The interest exclusion phases out for incomes between $128,650 and $158,650 (in 2022) for married couples filing jointly or $100,800 for individuals.
- If bond proceeds are not used for qualifying education expenses, the interest earned will be included in federal income and subject to tax.
Summary:
Qualified U.S. Savings Bonds are ideal for risk-averse investors who seek a low-risk environment to save their money without expecting significant growth. They are also advantageous for those saving for higher education expenses for themselves or a dependent.
However, investors should be mindful of the annual investment limit, income phase-out threshold, and tax implications before investing in savings bonds.
Deciding What is Best For You
Trying to determine the right college savings approach for you – and your child or grandchild – can lead to some difficult decisions. Here are some questions we think are important to answer as you try to decide which savings option might be the best fit.
- Will you only be using the funds for college expenses? If so, 529 plans offer the most tax benefits. But it’s critically important to remember that penalties will be imposed if the funds are used for anything else.
- Do you anticipate needing to use the funds for expenses beyond college, such as rent or a car? If flexibility is important, custodial accounts and taxable investment accounts may be better options since they do not have penalties for non-college expenses.
- Will you be relying on federal financial aid to pay for college? Be careful about which accounts you withdraw from since the student's income will be taken into consideration for financial aid purposes and can disqualify them from certain programs.
- How much do you plan to save for college? Some accounts have contribution or income limits, such as the Coverdell ESA which allows only $2,000 in contributions per year for individuals earning under $110,000 ($220,000 for married couples).
Considering these questions can help you make a more informed decision about which college savings account will work best for you and your family.
Offsetting Some of Your College Costs
Here are some ways you and your college student can pay for college beyond the previously mentioned educational savings accounts?
- Apply for Scholarships: Many organizations and churches in your community, or the school you will be attending, offer scholarships that could cover some or all of your college expenses. And no scholarship is TOO SMALL! Even smaller scholarships of $500 or $1,000 can add up over time.
- Find Grants: Grants are free money that can be applied directly to your college costs. Look for grants that you may be eligible for and apply.
- Work During the Summer: Your student should consider getting a part-time job during the summer to earn extra money to pay for miscellaneous expenses. Search platforms like Care.com to find flexible work options such as babysitting or dog walking if a more traditional job is not an option.
- Earn College Credit in High School: Taking Advanced Placement courses in high school or enrolling in dual enrollment programs at a local community college can help you earn college credits and reduce some of your tuition costs. Ensure that the college you will be enrolled in recognizes these credits as a contribution toward your diploma’s credit requirement!
- Use Loans as a Last Resort: While student loans can be helpful, they can also be expensive. One should typically exhaust all other options before considering loans as a last resort.
There’s No Perfect Option
While the most suitable approach for saving for college may vary from family to family, one thing is certain: it's never too soon to begin.
Whether you prefer investment accounts that offer versatility in spending or are willing to allocate funds exclusively for educational costs, there are a variety of college savings alternatives at your disposal. The most important thing is to get started.
Contact a DR Bank representative today to learn more about how we can help you and your family prepare for a successful financial future.
