Smart Strategies For Investing Your Child's College Fund

There are several options for parents who want to start investing in their children's education, including 529 plans, Coverdell Education Savings Accounts, UGMA accounts, and Roth IRAs. Each option has its own set of rules, tax implications, and investment choices. For instance, a 529 plan offers tax benefits, allowing savings to grow tax-free and providing a tax deduction on contributions in certain states. However, withdrawals for non-educational purposes incur penalties. On the other hand, a Coverdell ESA has a maximum contribution limit of $2,000 per year and is only available to those below a certain income level, but it offers federal tax advantages and can be used for various education levels. UGMA accounts provide more flexibility in terms of fund usage but are considered when applying for financial aid, impacting the amount of financial aid offered. Lastly, a Roth IRA offers tax-free growth and allows for tax- and penalty-free withdrawals of contributions, but there are income and contribution limits.

529 plans: A tax-advantaged way to save for college, with investment earnings growing tax-free

529 Plans: A Tax-Advantaged Way to Save for College

Named after Section 529 of the Internal Revenue Code, 529 plans are tax-advantaged savings plans designed to help pay for college expenses. They are sponsored and run by the 50 states and the District of Columbia. Anyone can open a 529 account, but they are typically established by parents or grandparents on behalf of a child or grandchild, the account's beneficiary.

The money in a 529 plan grows tax-deferred until it is withdrawn. As long as the money is used for qualified education expenses as defined by the IRS, withdrawals are exempt from state or federal taxes. The two main types of 529 plans are:

• Education savings plans: These are more common and offer tax-deferred growth. Withdrawals are tax-free when used for qualified education expenses. These plans remain under the control of the donor.
• Prepaid tuition plans: These plans enable account owners to lock in current tuition rates for future attendance at selected colleges and universities. Prepaid plans are not available for K-12 education.

There are several benefits to 529 plans:

• Tax advantages: Investment earnings from the account grow free of federal taxes if used for qualifying college expenses. Some states also offer tax deductions or credits for contributions.
• Flexibility: If your child doesn't need the funds, you can transfer the plan to another child or grandchild, or even use it for your own qualified educational needs.
• High contribution limits: There are no limits on how much you can contribute to a 529 account each year, although there are limits on the total amount over time, ranging from $235,000 to $575,000.
• Easy to open and maintain: Anyone can open a 529 plan, regardless of income level, and they are simple to set up and maintain.

There are also some potential drawbacks to consider:

• Limited investment options: 529 plans usually offer a preset selection of investment options, often through mutual funds or ETFs.
• Fees: All 529 plans have fees, and these can vary depending on the state.
• Restrictions: There are restrictions on switching plans and investments.
• Penalties: Non-qualified withdrawals or transfers are fully taxable and may carry penalties.

When choosing a 529 plan, consider the investment options, fees, and any tax benefits you may be eligible for. You can open a direct-sold 529 plan by completing an application on the plan's website, or an advisor-sold plan through a licensed financial advisor. Remember, the earlier you get started, the better – your money will have more time to grow and compound.

Coverdell Education Savings Accounts: Tax-free savings account with a $2,000 annual contribution limit

A Coverdell Education Savings Account (ESA) is a trust or custodial account set up in the United States to pay for the qualified education expenses of the designated beneficiary. The account is named after the late Senator Paul Coverdell of Georgia, who sponsored the legislation that created it.

Coverdell ESAs are tax-advantaged, allowing tax-free investment growth and tax-free withdrawals when the funds are used for qualified education expenses. The annual contribution limit is $2,000 per beneficiary, and the total maximum contribution per year for any single beneficiary is $2,000. This means that if multiple accounts are set up for the same beneficiary, the total contribution across all accounts cannot exceed $2,000 per year.

Coverdell ESAs can be used to pay for a wide variety of expenses for young people attending eligible schools, including tuition, books, equipment, special needs services, and academic tutoring. The accounts can be used for primary, secondary, and higher education.

There are some important restrictions to note. Firstly, the designated beneficiary must be under the age of 18 when the account is established, although this age restriction may be waived for special needs beneficiaries. Secondly, Coverdell ESAs are only available to families below a specified income level. For single taxpayers, the modified adjusted gross income (MAGI) must be below $95,000 to qualify for the full $2,000 contribution, and the limit is completely phased out for those with a MAGI of $110,000 or more. For married taxpayers filing jointly, the limit is $220,000, and it is completely phased out for those with a MAGI of $220,000 or more. Finally, any funds in the account must be used by the time the beneficiary turns 30, or taxes, fees, and penalties will be incurred on withdrawals.

UGMA accounts: Custodial account that allows minors to own investments, but counts against financial aid

UGMA accounts, which fall under the Uniform Gift to Minors Act, are custodial accounts that allow minors to own investments like stocks, mutual funds, cash, and bonds. The key difference between UGMA and UTMA accounts is that UGMA accounts allow gifts of cash or securities to be given to minors without tax implications up to gift tax limits, while UTMA accounts expand the types of gifts to include property and other transfers.

UGMA accounts are a good option for those who want their children to have flexibility in using their funds. The money in these accounts can be used for anything, including college expenses or other educational costs. However, it is important to note that UGMA accounts count against the student and parent when applying for college financial aid, which can reduce the amount of financial aid offered by the school.

UGMA accounts are easy to set up and do not require the creation of a trust, which can be costly and time-consuming. Additionally, there are no contribution limits, and anyone can contribute. While there are no tax benefits associated with UGMA accounts, a portion of any earnings may be exempt from federal income tax.

When considering a UGMA account, it is important to keep in mind that the assets in the account must be transferred to the child when they reach the age of majority, which varies by state. At that point, the child has full control over the assets and can use them for any purpose.

IRA accounts: Can be used for college payments if contributions have been made for at least five years

While Individual Retirement Accounts (IRAs) are usually associated with retirement savings, they can also be used to pay for college. IRAs can be a good option for parents or prospective students who want to start investing in their or their child's educational future. According to a 2020 Sallie Mae and Ipsos survey, 14% of parents withdrew from their retirement savings, including IRAs, to pay for college, up from just 6% in 2015.

IRAs can be used for qualified college payments as long as the contributions have been made for at least five years. This means that if you have had the IRA for less than five years and withdraw not just the principal amount contributed but also the earnings to pay for college, those earnings are taxable. For example, if a parent has contributed $30,000 into a Roth IRA that has grown to $45,000 with earnings, they can use up to $30,000 – the contributed amount – to pay for school expenses without any tax liabilities if five years have not yet passed.

There are two types of IRAs: traditional and Roth. The difference is that you pay taxes on the funds before you put the money into a Roth IRA, whereas a traditional IRA is funded by pre-tax dollars. Withdrawals from a traditional IRA are therefore taxable, whereas withdrawals from a Roth IRA are not. For this reason, the Roth IRA is preferable over the traditional IRA when paying for college.

It is important to note that using an IRA to pay for college may cause the student to receive less financial aid. This is because money withdrawn from an IRA will count as income and may affect a student's financial aid two years after the withdrawal. One strategy to mitigate this is to withdraw and use the IRA money during the student's junior and senior years when it will no longer be considered on the student's FAFSA (Free Application for Federal Student Aid) in determining financial aid eligibility.

Custodial Roth IRA: A tax-advantaged retirement account that an adult manages for a child

A Custodial Roth IRA is a tax-advantaged retirement account that an adult, usually a parent, opens and manages for a child. The account is owned by a minor but controlled and funded by an adult custodian until the minor reaches legal adulthood. The custodian makes decisions about contributions, investments, and distributions, and statements are sent to them. The minor remains the beneficial owner and the funds must be used for their benefit.

There is no age limit for a Custodial Roth IRA, but the child must have earned income, such as from a part-time job, and stay within contribution limits. The contribution limit for 2024 is $7,000 or the total amount of money the child made during the year, whichever is less.

The main benefit of a Custodial Roth IRA is that contributions can be withdrawn at any time, tax-free and penalty-free. This provides flexibility for the child who can access their cash, while also allowing parents to ensure some cash is being saved for the future. The account also provides tax-free growth, and the longer the time horizon, the more growth can be expected.

The account must be converted to a regular Roth IRA when the child reaches legal adulthood, usually 18 or 21, depending on the state. At this point, the child will need to understand how to manage the account and continue making contributions.

Custodial Roth IRAs are a great way to teach children about saving for retirement and investing, and the money can also be used for other important life events, such as buying a home or paying for college.

Frequently asked questions