The cost of college is skyrocketing, so it's no surprise that you're thinking about how to save for your grandkids' education. There are several options for investment accounts that can help you save for your grandchildren's future and limit your tax liability. Here's a paragraph introducing the topic of investing for college savings for your grandkids:
The rising cost of college can be a burden for families, but grandparents can help alleviate this financial strain by investing for their grandchildren's education. There are various investment accounts, such as 529 plans, Coverdell Education Savings Accounts, and custodial accounts, that offer tax advantages and flexibility for saving for college. These plans can help you save for tuition, fees, room and board, and other expenses related to higher education. By starting early and investing steadily, you can give your grandchildren a head start and protect them from taking on costly student loans. In this article, we will discuss the different investment options, their benefits, and how to get started on saving for your grandkids' college education.
Characteristics | Values |
---|---|
Type of Account | Custodial Accounts (UGMA/UTMA), 529 College Savings Plans, Series I or EE Bonds, Certificates of Deposit (CDs), Youth Savings Accounts, Joint Brokerage Accounts, Traditional and Roth IRAs, Coverdell Education Savings Accounts, Custodial Individual Retirement Accounts (IRAs), Prepaid Tuition Plans, Education Trusts, US Savings Bonds |
Tax Implications | Tax-free withdrawals for qualified educational expenses. Tax-deductible contributions to Traditional IRAs. No taxes owed upon withdrawal from Roth IRAs. |
Contribution Limits | $17,000 per individual or $34,000 per married couple in 2023 ($18,000 and $36,000 in 2024) to avoid triggering gift tax. $6,500 limit on contributions to Roth IRAs for 2023. |
Control Over Funds | Custodial accounts allow the custodian to control the account until the grandchild reaches adulthood. 529 plan owners control the funds even after the beneficiary turns 18. |
Investment Options | Stocks, bonds, mutual funds, exchange-traded funds (ETFs), target date funds, index funds, actively managed mutual funds |
What You'll Learn
Custodial accounts
- No rules on spending: Money in a custodial account can be spent on anything that benefits the minor, including laptops, smartphones, clothing, and other school-related items. This flexibility is especially useful if the child decides to start a business instead of pursuing higher education.
- No limits on contributions: Anyone can contribute any amount of money to a custodial account. While there are no contribution limits, it's important to be mindful of federal gift taxes, which may add up with large donations.
- Plentiful investment options: Custodial accounts can invest in stocks, bonds, and mutual funds. UTMA accounts offer even more investment options, including real estate and collectibles.
- Convenience: Custodial accounts are easily accessible, as most banks and financial institutions offer them.
However, there are also some downsides to custodial accounts:
- Limits on financial aid: Custodial accounts can negatively impact financial aid eligibility. Student assets in a custodial account reduce the need-based financial aid by 20-25% of the asset value, which is significantly higher than the maximum 5.64% reduction for a 529 plan.
- Better alternatives for taxes: 529 plans offer superior tax advantages compared to custodial accounts. 529 plans allow tax-deferred growth, and withdrawals are tax-free for qualified higher education expenses.
- No change of beneficiaries: Unlike 529 plans, you cannot change the beneficiary on a custodial account.
Overall, if you believe your grandchild will require significant financial aid, a custodial account may not be the best option. However, it is still worth considering, especially if you want more flexibility in how the money is spent and the ability to contribute larger amounts.
529 college savings plans
There are two types of 529 plans:
- College Savings Plans: These plans work like other investment plans such as 401(k)s and individual retirement accounts (IRAs). Your contributions are invested in mutual funds or other investment products, and account earnings are based on the market performance of these underlying investments. Most plans offer age-based investment options that become more conservative as the beneficiary nears college age. The 529 savings plans can only be administered at the state level.
- Prepaid Tuition Plans: Prepaid tuition plans, also called guaranteed savings plans, allow families to lock in today's tuition rates by pre-purchasing tuition. The program pays out at the future cost to any of the state's eligible institutions when the beneficiary is in college. If the beneficiary attends an out-of-state or private school, you can transfer the value of the account or get a refund. Prepaid tuition plans can be administered by states and higher education institutions, but only a limited number of states offer them.
The money in a 529 plan grows tax-free, and withdrawals for qualified education expenses are also tax-free. There is a low minimum contribution amount, usually around $25, and plans often have high limits on contributions, which are made with after-tax dollars. You can contribute up to the annual exclusion amount each year, which was $17,000 in 2023 and will increase to $18,000 in 2024. Withdrawals from 529 plans can be taken at any time and for any reason, but if they are not used for qualified education expenses, they may be subject to federal income taxes and a 10% federal penalty tax.
Anyone can open a 529 plan, regardless of income level, as long as they are a US resident, aged 18 or over, with a US mailing and legal address, and a Social Security number or Tax ID. The beneficiary can be anyone, of any age, with a Social Security or Tax ID number, and can even be the same person who sets up the account.
When deciding whether to invest in a 529 plan, consider the following:
- How much to save: 529 plans can subsidize part or all of a student's education expenses. Use a college savings estimator to determine how much you need to invest.
- When to begin: The sooner you invest, the more likely your 529 plan account will gain in value and grow to cover college expenses.
- Tax benefits: While 529 plans usually enable investors to defer federal taxes, state-level tax benefits vary depending on where the account owner and beneficiary reside ("in-state" vs. "out-of-state" plans).
- Fees: Carefully evaluate the fee structure of each 529 plan, as fees may impact earnings.
- Timing of withdrawals: Decide whether to use 529 plan savings for undergraduate costs, defer for graduate studies, or use for other eligible expenses.
- Taxes and penalties: Withdrawals for anything other than qualified expenses may incur penalties and applicable state and/or federal taxes. Transferring 529 plan assets to another beneficiary can help avoid penalties and maintain tax benefits.
Series I or EE bonds
Series I and EE bonds are savings bonds that can be purchased directly from the US Treasury through the TreasuryDirect website. They are a good option for grandparents looking to save for their grandchildren's college education.
Series I Bonds
Series I bonds are low-risk and provide some protection against inflation. They have a combined fixed rate and a variable rate that's adjusted twice a year for inflation. The variable rate adjusts higher or lower as inflation rises or falls, offsetting the impact of inflation and protecting the money's purchasing power.
The interest rate of an I bond will never fall below zero and it earns interest for up to 30 years or until it is cashed in. I bonds are currently earning 3.11% (as of November 2024) and anyone who purchases the bond while it offers that rate (through April 30, 2025) will enjoy the payout for a full six months. After that, they will enjoy the new interest rate announced in April for an additional six months, and so on.
I bonds are tax-free at the state and local levels. If the bonds are used for qualified education expenses, taxpayers may also exclude the interest on their bonds from their federal tax returns.
I bonds cannot be cashed in for the first 12 months that they are owned and if they are cashed in before five years, the owner will surrender the last three months' worth of interest.
Series EE Bonds
Series EE bonds earn a fixed interest rate for 30 years (or until they are cashed in) and the Treasury guarantees that they will double in value in 20 years. The interest rate is fixed for the first 20 years and may change after that for the last 10 years.
EE bonds are exempt from state and local taxes but are not exempt from federal taxes. However, the owner may receive tax relief if the funds are used for qualified higher education.
Like I bonds, EE bonds cannot be cashed in for the first 12 months and if they are cashed in before five years, there is a three-month interest penalty.
Pros and Cons of Series I and EE Bonds for College Savings
Both Series I and EE bonds can be a good option for grandparents looking to save for their grandchildren's college education. They are low-risk, provide some protection against inflation (in the case of I bonds), and offer tax advantages if used for qualified education expenses.
However, there are some drawbacks. Firstly, the federal tax exclusion is only available if the bonds are used for educational purposes. Secondly, the yield may adjust lower over time, especially if inflation falls. Finally, the bonds may not yield and compound as well over time as other investments, such as a well-diversified portfolio of stocks.
Certificates of deposit (CDs)
CDs generally pay higher interest rates than savings and money market accounts, making them an attractive option for savers who want to earn more without taking on more risk. The longer the term, the higher the interest rate. For example, investing $2,000 into a competitive one-year CD with a rate of 5% APY or more could earn you over $100.
CDs are a safer and more conservative investment than stocks and bonds, but they offer a lower opportunity for growth. They are also protected by the same federal insurance that covers all deposit products. The Federal Deposit Insurance Corp. (FDIC) insures bank accounts, and the National Credit Union Administration (NCUA) insures credit union accounts. In both cases, up to $250,000 of your funds are protected in the rare event that the institution fails.
CDs are a good option if you have cash that you don't need now but will want within a few years. They can help you save for a vacation, a new home, or a car. CDs can also be a good choice if you want to invest some of your savings more conservatively, achieving lower risk and volatility than the stock and bond markets.
One downside of CDs is that your money is locked into the investment. However, this can be beneficial for savers who worry about withdrawing from their savings. The fixed term of a CD and the penalty for early withdrawal can deter spending.
When opening a CD, consider these factors:
- Interest rate: Most CD interest rates are fixed, though there are variable-rate CDs that could earn a higher return if rates rise.
- Term: The length of time you agree to leave your funds deposited to avoid any penalty (e.g., 6-month CDs, 1-year CDs, etc.).
- Principal: The amount you agree to deposit when you open the CD.
- Financial institution: The bank or credit union where you open your CD will set factors such as early withdrawal penalties (EWPs) and whether your CD will default to being automatically reinvested at maturity.
CD ladders are another strategy to consider. This involves investing in multiple CDs with different maturity dates, allowing you to access the higher rates offered by longer-term CDs while still having a portion of your money become available at regular intervals.
Overall, CDs can be a great option for investing in shorter-term goals for your grandchildren, providing a guaranteed rate of return with a low risk of losing money.
Youth savings accounts
- Fees and minimum balance requirements: Youth savings accounts typically have no monthly maintenance fees and low minimum balance requirements, making them accessible to children with small amounts of money to deposit.
- Age limits: Youth savings accounts usually have age restrictions, with some catering specifically to younger children, teens, or those under 18. It's important to consider the age of your grandchild and how they will use the account.
- Parental controls: Many youth savings accounts offer parental controls, allowing parents to set limits on withdrawals and transfers. This can be a useful feature for grandparents who want to help their grandchildren develop healthy money management skills.
- ATM and debit card access: Some youth savings accounts offer ATM or debit cards, while others do not. If you want your grandchild to have access to a debit card, consider choosing an account that offers this feature or one that can be paired with a teen checking account.
- Interest rates: While youth savings accounts often offer higher interest rates than adult accounts, these rates may only apply to a small portion of the balance. For example, an account might offer a high APY on the first $1,000 but a much lower rate on any additional funds.
- Mobile banking: Look for an account with a user-friendly mobile app that offers features such as automatic transfers, savings goals, and parental controls. This can make it easier for your grandchild to track their savings progress and develop good financial habits.
- Capital One's Kids Savings Account: This account offers interest on all balance amounts, the ability for kids to upgrade to a checking account as they get older, and the option to set specific savings goals in the app. It also has a top-rated mobile app with parental controls.
- USAlliance Financial's MyLife Savings for Kids: This account is ideal for younger grandchildren, offering a $10 "birthday bonus" each year until the child turns 13. It also pays a competitive interest rate of 2.00% APY on the first $500.
- Alliant Credit Union's Kids Savings Account: This account offers a competitive interest rate of 3.10% APY with no maximum balance, a mobile banking app with child- and parent-friendly features, and the option to add a teen checking account with a debit card at age 13.
- Spectrum Credit Union's MySavings Youth Account: This account offers an exceptionally high interest rate of 7.00% APY on the first $1,000, though joining the credit union requires a membership fee.
- Northpointe Bank's Kids Savings Account: This account is well-suited for older grandchildren, offering a strong APY of up to 1.50% for balances up to $1,000. It also offers the option to add a checking account with a debit card.
Frequently asked questions
A 529 plan is a tax-advantaged investment plan that lets families save for future college costs for a beneficiary. The money grows tax-free and withdrawals for qualified education expenses are also tax-free. In 2023, you can contribute up to $17,000 per year per individual ($34,000 for married couples filing jointly) without triggering the gift tax.
There are two types of 529 plans: College Savings Plans and Prepaid Tuition Plans. College Savings Plans work like other investment plans such as 401(k)s and individual retirement accounts (IRAs), with contributions invested in mutual funds or other investment products. Prepaid Tuition Plans allow families to lock in today's tuition rate by pre-purchasing tuition.
One of the pros of using a 529 plan is that it offers tax advantages for both the beneficiary and the account owner. Additionally, 529 plans have high limits on contributions. However, a downside is that the account owner loses control of the funds once contributions are made. Also, 529 funds can only be used for qualified educational expenses.
Some alternatives to 529 plans include custodial accounts (UGMA/UTMA), Series I or EE bonds, certificates of deposit (CDs), youth savings accounts, traditional and Roth IRAs, Coverdell Education Savings Accounts, and U.S. savings bonds.
Some tips for building savings for grandkids include developing a savings plan, making regular contributions, incrementally increasing contributions over time, diversifying investments, and regularly reviewing and adjusting your savings strategy.