If you’re ready to start saving for your children’s higher education expenses, then you may be wondering where you should put your money in order to receive the best benefit. Thankfully, you have a myriad of investment options for college savings. Let’s look at the most popular.
Created in 1996 and authorized by Section 529 of the Internal Revenue Code (IRC), 529 plans are legally known as “qualified tuition plans” and are sponsored by states, state agencies, or educational institutions. There are two types of 529 plans – the prepaid tuition plan and the college savings plan – and each state offers at least one type of 529 plan.
With the prepaid tuition plan, you can pre-pay all or part of the costs of an in-state public college education and lock in current tuition rates. The plan can be converted to private or out-of-state schools if your children do not choose in-state public schools, but the process to do so may be difficult.
With the college savings plans, you can invest contributions in mutual funds, index funds, or similar investment accounts that states, agencies, or educational institutions have chosen. You are not required to invest in your home state’s plan because any 529 plan can be used to pay for qualified higher education expenses at any eligible college nationwide. However, some states offer income tax deductions or credits if you invest in your home state’s plan.
529 plans are probably the most popular way to save for your children’s educations because of the tax advantages they offer. The idea behind the 529 plans is that you make after-tax contributions into investment plans, and the interest earnings on your contributions accrue tax-deferred. If you use the monies for qualified higher education expenses like tuition and fees, books, supplies, room and board, etc., the money is never taxed! However, if you withdraw the money for any other reason, the earnings will be subject to ordinary income taxes and a 10% tax penalty.
Like many investment plans, the 529 Saving Plan has contribution limits. Yet, one of the many benefits of a 529 plan is that contributions are considered “gifts” for tax purposes. Thus, as of 2019, you can contribute up to $15,000 per year or a lump sum of $150,000 split between two parties every 5 years without tax penalties.
Another great way to save for your children’s college education is through a Coverdell Education Savings Account, or an ESA. Originally called an Education IRA, the ESA is a tax-deferred trust account created by the United States government to assist families in funding education expenses for beneficiaries 18 years old or younger.
Much like 529 plans, ESA’s grow tax-deferred, and you can withdraw your contributions and earnings for qualified college education expenses tax-free! An added bonus to these types of accounts is that you can withdraw the monies tax-free for qualified elementary and secondary education costs as well. Additionally, you can invest in almost any security – stocks, bonds, and funds – rather than being limited to funds.
Unfortunately, the maximum contribution limit for an ESA is much lower than the limit for 529 plans, topping out at $2,000 per child per year, and they are only available to families who fall under a designated income level. Nevertheless, they can still play a valuable role in your college savings plans.
If you aren’t sure whether or not your child will attend college, an UTMA account might be the right investment option for you. The Unified Transfer to Minor Act is a custodial trust savings account which is used to hold and protect gifted assets for minors until they reach the age of maturity in their states (usually 18 or 21). UTMA accounts allow minors to own cash securities. They can own real estate, fine art, patents, and royalties.
Since the IRS allows exclusions from the gift tax up to $15,000 annually for qualifying gifts to minors, a person can contribute or “gift” up to $15,000 per year into the UTMA account. Assets are then counted as part of the custodian’s taxable estate until the beneficiary takes possession at age 18 or 21. At that time, beneficiaries can withdraw and use the assets for any purpose. They are not required to use the money for college expenses. However, since the account and its assets are in the child’s name, the government may be reticent to issue financial aid to the beneficiary of the assets for college expenses.
The next investment vehicle, a cash value life insurance plan, may not top your list for college savings plans. However, the funds in the insurance savings plan grow tax-deferred, and you can withdraw portions of the cash value for any purpose. That buildup in funds can help offset college costs, especially if you’re looking to bypass the restrictions of a 529 Plan or an ESA or you don’t want to deal with the taxation that accompanies a UTMA.
If you go this route, though, you’ll definitely want to work with advisors who will help keep the policy from being commission-heavy. They can help you find a policy with the highest premium allowed and the lowest death benefit. (No! I did not mess up there. That is exactly what you want. high premium and low death benefit.) However, you have to be careful with these… you don’t want to pass the modified endowment contract (MEC) threshold. That means if you put too much into the life insurance premium, the IRS will say you’re not using this properly as an insurance policy. When you take the money out, they’ll tax you on it. If that happens, you’d want to take the money and put it into a UTMA. So it is possible to receive a better rate of return if you set it up right.
Another unconventional way to save for your children’s college education is through a Roth IRA. Many times, I hear people tell me they can’t fund their retirement, pay down their debt, AND save for college. That’s where a Roth comes into play. You can save for retirement and pay for your kids’ college educations with after-tax money you invest!
Obviously, Roth IRAs are typically used for retirement purposes. However, the IRS will let you withdraw money tax and penalty free if you follow a certain set of rules. You are able to withdraw your contributions to the Roth IRA at any time. If you desire to withdraw the earnings, then the earnings must have been in the account for five years. If the earnings have been in the account for 5 years and you are over the age of 59 1/2, then you can withdraw the funds tax and penalty fee. However, if you are under the age of 59 1/2, you will want to limit your withdrawals to your contribution amounts to pay for higher education expenses and avoid penalties. Just remember, the more you withdraw for your children, the less money you have for your own retirement.
You may even want to take a completely different approach and not save at all. Perhaps you need to pay down your own debt before you think about saving for your children’s higher education. Although each of the investment strategies I’ve listed above are great ways to help you tackle college expenses, you’ll definitely want to talk to your CERTIFIED FINANCIAL PLANNER™ to figure out which fits your situation best. If you don’t have a planner, you are welcome to contact us for help deciding how to make your college savings financially simple.
RELATED POST: When is the best time to start saving for college?