An Overview of College Savings Plans
Encouraging your children to go to college and get a good education is one of the best things you can do for them. But saving for college, even with scholarship help, can be daunting and expensive.
Moreover, it can be downright scary when you consider that so many graduates struggle with the weight of student loan debt when college is over. And many of today's parents are still paying off their own student loans, even as the cost of college for their kids is four times greater then when they went to school.
The good news is that there are a variety of college savings plans out there that ease the costs and help ensure that your children will get the best education possible.
Among those plans are:
- 529 Plans
- Roth IRAs
- Prepaid Tuition Plans
- Coverdell Savings Accounts
- UGMA and UTMA Custodial Accounts
Here's a look at each of those plans:
Legally known as "qualified tuition plans", 529 plans are sponsored by states and state agencies, or educational institutions.
A 529 plan offers tax advantages because in most cases your earnings aren't subject to federal income, or state taxes. You maintain those advantages by only using the withdrawals for legitimate college expenses such as tuition and room and board.
If you do withdraw money for something other than eligible college expenses, you will be subject to normal income tax as well as an additional 10% federal tax penalty.
There may be fees and expenses associated with 529 plans depending on whether you purchase the plan through a state sponsor or a broker. With a broker, there may be additional fees, called a "load," that is paid to the broker as commission for the sale.
Note: Taking precautions when first setting up the plan can protect the 529 in the event of a divorce. Because it's not the child's asset, but an asset of the marriage, it can be wise to divide the account equally between both spouses. Also, the divorce decree should specify exactly how the 529 funds will be used.
While it's most commonly viewed as a tax-advantaged retirement plan, a Roth IRA can help pay for some college expenses.
The tax advantages of a Roth IRA include funding it with after-tax money and withdrawing gains later tax-free, usually after age 59 1/2. A Roth also allows you to take out up to $10,000 tax-free and penalty-free (without the 10% federal tax penalty for early withdrawal) for qualifying college expenses after five years.
A Roth IRA also allows you use the funds for retirement if your child doesn't go to college.
Prepaid Tuition Plans
The beauty of prepaid tuition plans is that they allow you to pay for portions of your child's education now by locking in at current college prices. This protects you from tuition hikes if your child is still years away from attending college.
Not all states offer prepaid tuition plans, however, and some may be closed to new enrollment.
Coverdell Education Savings Account
A Coverdell ESA (formally known as an education IRA) is similar to a 529 plan in that it's tax-advantaged if you used to pay for educational expenses. Unlike a 529, the money can be used to cover any educational expenses - not just college - including K-12 expenses such as private school tuition.
The Coverdell ESA college savings plan is considered the parent's asset, not the child's, so it doesn't hinder your child's chances of getting financial aid.
You can set up an account for each child, but the total maximum contribution per year for each child is $2,000.
UGMA & UTMA Custodial Accounts
In these accounts, financial gifts to a minor are held in a custodial account until the child reaches adulthood, and can be another option for a college savings plan.
These types of accounts offer less tax advantages than 529 plans. Additionally, they can be considered your child's asset, which can hinder the amount of federal aid your child can receive.
Under the current federal financial aid formula, a child must contribute 20% of his assets to college costs each year. For parents, it's only 5.6%. Thus, the more assets a child has, the more her or she will be asked to contribute to college costs - and hinder efforts to receive financial aid.
By giving the Gift of College, other family members and friends can give a gift directly to 529 college savings plans. As a parent, you can create a profile for your child and friends and family can give a gift that way. And you can encourage friends to make a gift this way for birthdays, holidays and other occasions.
By gifting them to a 529 plan, the funds also remain an asset of the parents, not the child.
Savings is one piece of the puzzle. Another crucial piece you'll use in paying for college is to learn about your child's financial aid options.