College Fund Investment: Strategies For Financial Security

The cost of college is rising, and many students graduate with tens of thousands of dollars of debt. One way to help your child transition into a successful adulthood is to start a college fund. There are several options for where to save for college, including 529 plans, Roth IRAs, savings bonds, Coverdell Education Savings Accounts (ESAs), and custodial accounts. Each has its own advantages and disadvantages in terms of tax benefits, contribution limits, investment options, and flexibility. For example, 529 plans are a popular education-specific savings plan that offers tax advantages and high contribution limits, while Coverdell ESAs have lower contribution limits but can be used for a wider range of educational expenses.

529 plans

There are two main types of 529 plans: education savings plans and prepaid tuition plans. Education savings plans offer tax-deferred growth, and withdrawals are tax-free when used for qualified education expenses. These plans remain under the control of the donor, usually a parent. Prepaid tuition plans, on the other hand, allow account owners to lock in current tuition rates for future attendance at selected colleges and universities.

There is no cap on yearly contributions to a 529 plan, but there is a total maximum contribution over the life of the account, which varies by state. For example, in North Carolina, the maximum contribution is $550,000, while in California, it is $575,000. Additionally, deposits up to $18,000 per year per individual are exempt from the annual gift tax.

Funds from a 529 plan can be used to pay for a wide range of college expenses, including tuition, fees, room and board, books, and other related costs. They can also be used for K-12 tuition, up to $10,000 per year, per child, as well as trade schools, apprenticeship programs, and study abroad. Furthermore, up to $10,000 can be used to repay student loans for the account beneficiary or their siblings.

One of the key advantages of 529 plans is their tax benefits. In some states, qualified withdrawals for education costs are not subject to federal or state taxes. Additionally, contributions to a 529 plan may be tax-deductible for state taxes, depending on the state. However, it is important to note that if withdrawals are made for non-qualified expenses, they may be subject to taxes and a 10% penalty.

When choosing a 529 plan, it is important to consider the specific rules and fees, as they differ from state to state. It is also essential to start saving early and contribute regularly to maximize the benefits of compound interest.

Coverdell Education Savings Accounts

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 the designated beneficiary of the account. This includes both qualified higher education expenses and qualified elementary and secondary education expenses.

To set up a Coverdell ESA, the designated beneficiary must be under the age of 18 or be a special needs beneficiary. The account must be designated as a Coverdell ESA when it is created, and the document creating and governing the account must be in writing. Contributions must be made in cash and are not deductible. There is no limit to the number of accounts that can be established for a particular beneficiary, but the total contribution to all accounts on behalf of a beneficiary in any year cannot exceed $2,000. The beneficiary can receive tax-free distributions to pay for qualified education expenses.

Coverdell ESAs work very much like a 529 plan, offering tax-free investment growth and tax-free withdrawals when the funds are spent on qualified education expenses. However, Coverdell ESAs have much lower maximum contribution limits per child and are only available to families below a specified income level. For example, contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. The $2,000 maximum is gradually phased out if the modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers).

Coverdell ESA funds 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 even academic tutoring. The funds must be used by the time a student is 30, otherwise taxes, fees, and penalties will accompany withdrawals.

Custodial accounts

It is important to note that custodial accounts do not have the same tax advantages as some other college savings plans, such as 529 plans. Any earnings in the account are taxed at the child's tax rate, and the money in the account may impact the child's eligibility for financial aid. Additionally, once the child reaches the age of majority, they have legal control over the funds and can use them for any purpose, which may differ from the parent's original intentions.

Despite these considerations, custodial accounts can be a valuable tool for saving for a child's college education, especially for those who may need the funds for extra expenses outside of just college tuition.

Mutual funds

There are some downsides to investing in mutual funds for a college 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.

Savings bonds

Series EE and Series I savings bonds are available from the US Treasury Department and are considered a safe, guaranteed, and low-risk investment option. They are also backed by the full faith and credit of the US government. The interest accrued on these bonds is generally free of federal, state, and local taxes as long as they are used to pay for qualified college expenses. These expenses include tuition and fees for courses that count toward a degree or certificate program.

There are some important rules to keep in mind when purchasing savings bonds for college. Firstly, the bond buyer must be at least 24 years old, and the bonds must be registered in the parent's name if purchased for a child. There are also annual income limits for purchasing savings bonds. For example, for the 2016 tax year, married couples filing jointly could take the full tax exclusion if their income was below $116,300, while single filers could take the full exclusion if their income was below $77,500. Additionally, there are annual limits on the dollar amount of bonds that can be purchased. For instance, in 2016, individuals could purchase up to $20,000 in online/electronic savings bonds.

It is important to note that there are specific rules for using savings bonds for college expenses. The interest earned on the bonds can be used tax-free only if certain conditions are met. These conditions include using the funds for qualified educational expenses for oneself, a spouse, or dependents, and ensuring that the expense occurs in the same tax year in which the bonds are redeemed. Additionally, the qualified education expenses must not already be covered by financial aid, scholarships, or other tax breaks.

Frequently asked questions