College costs are spiraling to the point where a four-year major college education is approaching or exceeding the cost of your house. Like many Americans, you may not be able to foot the entire cost of a college education, but a prudent savings plan can reduce the amount of aid your child will have to seek – and ultimately, how much debt they will graduate with.
What are the best methods for saving for college? Here are a few:
- 529 Plans – 529 plans, named after Section 529 of the tax code, are investment accounts that are operated by states that allow anyone to contribute to funds for your child's education, building up funds tax-free as long as they are used for that purpose. They are great for allowing kids to contribute early to their own education funds.
The 2017 Tax Cuts and Jobs Act (TCJA) expanded the use of 529 education savings plan funds from covering only qualified college expenses to also include eligible private, public, or religious elementary or secondary school expenses. However, it limited the total amount payable for elementary or secondary tuition to $10,000 per year.
529s offer several investment options with varying degrees of risk and return. Many states let you select an automatic mix of primarily stocks in the early years, shifting to bonds or similar conservative investments closer to withdrawal time.
Accounts may require minimum contributions as low as $15 in some states, and there are no income or age limits. 529s can also be switched to a sibling if plans change, such as with a scholarship offer. You stay in control of the money, determining the amount and timing of withdrawals.
Your 529 does not have to be with the state you live in, nor does the university your child attends. However, there may be fewer investment options and higher fees for out-of-state use.
529's are considered gifts for tax purposes and are subject to gift tax limitations ($14,000 annually or $28,000 as a couple). You can make five years worth of contributions at one time if you prefer. There is a lifetime maximum, typically between $200,000 and $300,000, which varies from plan to plan. Since 529's are considered your asset and not your child's, this also has less of an effect on financial aid. There are heavy penalties for using 529's for things other than education, but if the need is no longer there due to a merit-based scholarship, you can recover the funds without penalty and with minimal taxes.
- Coverdell Educational Savings Account (ESA) – A Coverdell ESA is similar to a Roth IRA, except designated toward education, not retirement. You use after-tax dollars to contribute to the fund and can use them for virtually anything education-related, even K-12 expenses. Contributions stop at age 18 and are limited to $2,000 per child annually. The account will be distributed to your child if not used for college.
There are also income limits ($220,000 in modified adjusted gross income for married couples). Relatively low contribution amounts make Coverdell ESAs less useful by themselves, but they make a good complement to a 529 plan or another savings vehicle.
- Custodial Accounts –These can be savings accounts, or other investments, that are in your child's name but in your control as the custodian. There are few limitations on what you can contribute, they are easy to set up, and have no withdrawal limitations.
However, custodial accounts do not compare well to 529 plans for the following reasons: the majority of the funds are taxed at your tax rate; your child has complete control of the funds when they reach the age of majority (18 or 21, varying by state); they are counted as assets against financial aid; and you cannot switch beneficiaries. In general, a small custodial account is useful but a 529 is far preferable as the primary savings vehicle.
Some universities offer 529 prepaid tuition plans, which are not savings plans per se, but do save money long-term by locking in your tuition at current rates. If you know for sure your child is going to a participating university, this is a reasonable option.
It may be tempting, but do not sacrifice your retirement funds to save for college. There are other resources to deal with college costs and any incurred debt, but only you can handle your retirement costs, and you have a limited time to save.
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