Investing For Your Child's Future: College Fund Options

The cost of raising a child is high, and that doesn't include the expense of their postsecondary education. With the average cost of tuition at a public four-year in-state university at $10,740 for the 2021-22 academic year, it's no wonder that many parents are keen to start saving for their children's college education early.

There are several options for parents who want to start a college fund for their children, each with its own pros and cons. Here's an overview of some of the most popular options to get you started.

529 plans

There are two types of 529 plans: education savings plans and prepaid tuition plans. The former is more common and is available to everyone, though a few have residency requirements. The latter typically has residency requirements, though there are some exceptions.

Education savings plans allow a saver to open an investment account to save for the beneficiary's future qualified higher education expenses. These include tuition, mandatory fees, and room and board. Withdrawals can generally be used at any college or university, and can also be used to pay for other education-related expenses, such as tuition at an elementary or secondary school, expenses for registered apprenticeship programs, and qualified education loan repayments.

Prepaid tuition plans let a saver 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. The participating colleges and universities are typically public, in-state institutions in the state that sponsors the plan.

There are no annual contribution limits for 529 plans, but there are limits on the total in a given account, ranging from $235,000 to over $550,000.

Withdrawals from 529 plans are not subject to federal or state income taxes, provided the money is used for qualified educational expenses. Any other withdrawals are subject to taxes plus a 10% penalty, though there are some exceptions, such as after death or disability.

Contributions to 529 plans are not tax-deductible for federal income tax purposes, but more than 30 states provide tax deductions or credits of varying amounts for these contributions.

As of 2024, the annual gift tax exclusion is $18,000, meaning you can give up to this amount per year to any individual without it counting against your lifetime gift tax exemption. This means that a grandparent, for example, could make a one-time contribution of $90,000 to their grandchild's 529 plan without triggering gift tax consequences.

There are some restrictions on 529 plans. Investments in education savings plans have certain pre-set options, and under current tax law, an account holder can only change their investment option twice per year or when there is a change in the beneficiary. Withdrawals from education savings plans can only be made without incurring taxes and penalties for qualified higher education expenses or other specified expenses.

Benefits of 529 plans include:

• Minor impact on financial aid eligibility
• Federal tax treatment of gifts
• Earnings grow tax-deferred
• Tax-free withdrawals
• State tax incentives
• Roth IRA rollovers for unused funds

Potential drawbacks of 529 plans include:

• Must be qualified expenses
• Not all states offer deductions
• No self-directed investments
• Fees
• Ownership rules

Custodial accounts

There are two types of custodial accounts: the Uniform Transfers to Minors Act (UTMA) and the Uniform Gift to Minors Act (UGMA). The UTMA is allowed in all states except Vermont and South Carolina, while the UGMA is allowed in all 50 states.

UTMA accounts are more flexible and can hold a wider range of assets, including real estate, intellectual property, and works of art, in addition to stocks, bonds, mutual funds, annuities, and other insurance account assets. On the other hand, UGMA accounts can only hold basic investment vehicles such as stocks, bonds, mutual funds, and insurance-related investments.

• No income or contribution limits
• No withdrawal penalties
• No requirements for distributions
• A wide range of investment options
• Simplicity and low cost of establishing the account

However, there are also some downsides to custodial accounts:

• They may negatively impact the child's financial aid eligibility as the account is considered an asset owned by the minor.
• Any deposits or gifts made to the account are irrevocable and cannot be changed or reversed.
• Custodial accounts do not offer the same tax advantages as some other accounts, such as 529 plans.
• The beneficiary of a custodial account cannot be altered.

Savings bonds

There are, however, certain restrictions to be aware of. Firstly, the owner of the bond must be at least 24 years old when the bond is issued. Therefore, it is important to register the bonds in the parent's name, as a bond registered with a child as the owner will not qualify when the child is ready for college. Secondly, there are income limits for tax exclusion eligibility, which are set by the IRS and may change annually. For the 2016 tax year, for example, the income limit for a married couple filing jointly was $116,300 for the full tax exclusion, with a partial exclusion for incomes between $116,300 and $146,300.

Additionally, there are annual limits on the dollar amount of bonds that can be purchased. For 2016, individuals could purchase up to $20,000 in online/electronic savings bonds and up to $5,000 in Series I paper savings bonds through their federal income tax refund. It is also important to note that certain expenses are not considered qualified educational expenses, such as books and room and board.

Coverdell Education Savings Accounts (ESAs)

A Coverdell Education Savings Account (ESA) is a trust or custodial account set up in the United States to pay for qualified education expenses for a designated beneficiary. This includes elementary, secondary, and higher education expenses, such as room and board, tuition, books, equipment, and academic tutoring.

Earnings on the account accumulate tax-free, and distributions are also free of income taxes as long as they are used for educational purposes. The maximum contribution allowed is $2,000 per beneficiary per year, and contributions must be made before the beneficiary turns 18. The account can only be used until the beneficiary turns 30, after which any remaining funds must be disbursed.

Coverdell ESAs are available only to families below a certain income level. For 2024, the requirements are an adjusted gross income of $95,000 or less for single taxpayers and $190,000 or less for married taxpayers filing jointly. If you make more than that, the limits are $110,000 for single filers or $220,000 for married couples.

Coverdell ESAs are similar to 529 plans but have some key differences. Firstly, for elementary and secondary school, Coverdell funds can be used for other school expenses besides tuition. Secondly, Coverdell ESAs have much lower maximum contribution limits per child. Thirdly, Coverdell ESAs allow you to self-direct your investments, whereas 529 plans only allow you to select from a menu of investment options determined by the program manager.

Roth IRAs

A Roth IRA is a personal finance tool used for retirement that offers tax advantages. While it is not a great college savings tool, it can be used to save for your child's college education. Here are some of the pros and cons of using a Roth IRA to save for your child's college fund:

Pros

• Contributions can be withdrawn at any time for any reason without incurring income tax or penalties.
• Earnings and contributions grow tax-free.
• There is a broad range of investment options available.
• Once you reach the age of 59½, all money can be withdrawn tax- and penalty-free to help with children's and grandchildren's expenses.
• Any money that is not spent on college can remain in the Roth IRA to fund your retirement.

Cons

• The annual contribution limit is low compared to other college savings options. For 2024, the maximum investment allowed is $7,000, or $8,000 for those aged 50 or older.
• There is no state income tax deduction for Roth IRA contributions.
• Roth IRA withdrawals count as income for financial aid purposes and can affect the amount of aid offered.
• Using a Roth IRA for college savings reduces the amount of money that can be saved for retirement.
• There are income limits for contributing to a Roth IRA. For 2024, individuals earning $146,000 or more will see their contribution limits begin to phase out, and those earning $161,000 or more are ineligible.

Frequently asked questions