College Savings: Invest Wisely For Your Child's Future

With the cost of college education soaring, it's becoming increasingly important to start saving early for your child's future. The average college student graduates with a whopping $38,290 of student loan debt, and the overall student loan debt in the US stands at $1.6 trillion. A college fund is a tax-favored savings plan for college costs, and there are several options to choose from, each with its own advantages and disadvantages. This includes 529 plans, Coverdell Education Savings Accounts (ESAs), Roth IRAs, custodial accounts, mutual funds, and savings bonds. It's essential to carefully consider the pros and cons of each option and seek advice from a qualified professional to determine the best approach for your family.

529 plans

Education Savings Plans

Education savings plans are available to everyone, though some have residency requirements. They allow savers to open an investment account to save for the beneficiary's future qualified higher education expenses, including tuition, mandatory fees, and room and board. Withdrawals can generally be used at any college or university, and may also cover other education-related expenses such as elementary or secondary school tuition, apprenticeship programs, and qualified education loan repayments.

Savers can typically choose from a range of investment options, including various mutual fund and exchange-traded fund (ETF) investments, as well as static fund portfolios and age-based portfolios (target-date portfolios). The latter automatically shift funds into more conservative investments as the beneficiary gets closer to college age.

Prepaid Tuition Plans

Prepaid tuition plans allow savers to purchase units or credits for the beneficiary to use in the future at participating colleges and universities. The saver is essentially pre-paying future tuition and mandatory fees at current prices. These plans are typically offered by state governments and have residency requirements. They are less flexible than education savings plans, as the credits can only be used for future tuition and fees at certain schools.

Benefits of 529 Plans

Drawbacks of 529 Plans

Despite their advantages, 529 plans have some potential drawbacks. They offer limited investment options, and there may be restrictions on switching plans or investments. Fees can vary by state and plan type, and there may be tax implications if withdrawals are not used for qualified educational expenses.

Custodial accounts

Benefits

• Custodial accounts can be used to fund expenses that 529 plans and Education Savings Accounts (ESAs) don't cover.
• You can take advantage of the gift tax exclusion to fund the account.
• You can control how the money is invested while your child is still a minor.
• There is flexibility in terms of how the money is spent, as long as it is used for the benefit of the child.
• There are no limits to the amount of gift money you can contribute to these funds, but anything above $18,000 per year ($36,000 for a married couple) will be subject to a federal gift tax.

Drawbacks

• You can't change the beneficiary of a custodial account once it's established.
• Your child can use the money for anything they want after reaching a certain age.
• Investment income in custodial accounts may trigger the "kiddie tax".
• The account can impact financial aid eligibility.

Taxation

Financial Aid Eligibility

Savings bonds

There are specific rules for purchasing and using savings bonds for college. Bond buyers must be at least 24 years old, and the bonds must be registered in the buyer's name. For married couples, the bonds can be registered jointly. There are also annual income limits and annual purchase limits for the bonds. For example, in 2016, the income limit for a married couple filing jointly was $116,300 for the full tax exclusion, with a partial exclusion for incomes up to $146,300. The same year, individuals could purchase up to $20,000 in online/electronic savings bonds and up to $5,000 in Series I paper savings bonds.

One of the biggest advantages of savings bonds, particularly Series I bonds, is their inflation protection. The interest rate on Series I bonds consists of a fixed rate and a variable rate that adjusts to the level of inflation every six months, ensuring that the purchasing power of your money is protected. As of May 2024, the composite rate for Series I bonds was 4.28% annually. However, it is important to note that the yield may adjust lower if inflation decreases.

In conclusion, savings bonds, specifically Series EE and Series I bonds, are a safe and low-risk option for those seeking to save for college. They offer modest returns, tax advantages, and inflation protection, making them a compelling choice for those looking to secure funds for future education expenses.

Education Savings Accounts (ESAs)

An Education Savings Account (ESA) is a tax-advantaged college savings plan designed to facilitate a child's college education. It allows parents to invest a maximum of $2,000 per year, per child, and this money grows tax-free. The money in an ESA can be used for a variety of educational purposes, including K-12 private school tuition, vocational school, textbooks, school supplies, tutoring, and even some college expenses. It's important to note that contributions are limited to $2,000 per year and there are income limits to qualify for an ESA. Additionally, the funds in the account must be used by the beneficiary before they turn 30 years old.

ESAs are an ideal supplement to a 529 plan, another popular type of education savings account. While 529 plans offer tax benefits for qualified education expenses, ESAs provide more flexibility in how the funds can be used. For example, while 529 plans can only be used for qualified higher education expenses, ESAs can also be used for K-12 expenses. This makes ESAs a good option for parents who want to save for their child's education but are unsure if their child will attend college.

The money in an ESA can be invested in a variety of ways, including growth stock mutual funds, which can provide an average return of 10-12%. This means that if you invest $2,000 a year from the time your child is born until they turn 18, you could end up with around $112,000 by the time they are ready for college. This is a much higher rate of return than a regular savings account, and you won't have to pay taxes when withdrawing the money for education expenses.

However, it's important to note that ESAs have some restrictions. For example, if the beneficiary of an ESA decides not to go to college or doesn't need all the funds, the money can be transferred to another family member for their educational expenses. Additionally, rollovers from Traditional or Roth IRAs into an ESA are not allowed.

Overall, ESAs are a great option for parents who want to save for their child's education and have the potential to provide a significant return on investment. However, it's important to consider the restrictions and income limits associated with these accounts before deciding if an ESA is the right choice for your family.

Mutual funds

Earnings depend on mutual fund performance and may come from capital gains, dividends, or bond coupon payments. There are over 10,000 mutual funds available, with a wide variety of investment options, and there is no limit to how much you can invest.

However, mutual fund earnings are subject to annual income taxes, and any capital gains are taxed when you sell shares. Mutual fund assets owned by a parent will also impact financial aid eligibility. The FAFSA (Free Application for Federal Student Aid) considers money transferred from mutual funds to pay for college as income, which can reduce a student's aid package.

Frequently asked questions