If you follow the news, you’ve heard about the issues surrounding student loan debt. Recent reports from the New York Federal Reserve peg Americans’ outstanding student loan debt at $1.16 trillion, or an average of $33,000 per borrower.
• Which savings vehicles to use
• When to start saving for college
• How to maximize tax benefits
Each family’s situation is going to be unique, but understanding a few basic principles can help you make a confident, well-informed decision that benefits both you as the parent and your child as the student. With that in mind, we’ve asked Matt Becker, a fee-only financial planner and founder of the Mom and Dad Money for some insight on how to best save for college.
When is the Best Time to Start Saving?
A common question parents ask is, “when is the right or ‘best’ time to start saving for college?” As with anything related to investing, more time is always better because it gives funds more time to grow. Starting right away may not be possible for parents who need to get their financial house in order. As strong as a parent’s desire to provide for his or her child’s future is, there are some basic things to have in place before beginning saving for college.
According to Becker, “I usually recommend that people wait to start saving for college until they have other priorities like an emergency fund, insurance and their own retirement savings on track.” This perspective of covering personal needs first might seem selfish, but providing for a child’s college education at the expense of your own financial well being could create a situation where you end up being a financial burden to your child in your post-retirement years.
After covering those pressing needs Becker mentions, you should then start thinking about saving for college. These options can start with as little or as much as you want – don’t allow the amount to hold you back. There are several college savings options that can benefit both you and your child as he or she starts contemplating where to attend college and for what purpose. You may have heard that the 529 Plan is the best way to start saving, but there are other options worth considering – depending on your means and needs.
What are the Best Options?
As a parent, you might think there is only one option to consider when it comes to saving for college. There are actually three options and two of those are excellent candidates to consider.
Option #1 – 529 Plans
The 529 Plan is likely the most well known option when it comes to saving for college. There are several features that make 529 Plans attractive. According to Becker, “529 plans have the fewest limitations when it comes to contributions. There are no income limits, meaning anyone can contribute.” This means that regardless of your income level, you can contribute funds to a 529 Plan. Not only that, but funds in a 529 work like those invested in a Roth IRA in that the growth is tax free and are tax free upon withdrawal, assuming they are used for qualified educational expenses. You are also not obligated to invest in a 529 from your own state, which adds greater flexibility.
The amount you can put into a 529 also makes them a solid option to consider. Federal tax law allows you to contribute up to $14,000 per year without incurring the federal gift tax. The beauty lies in the gift tax exclusion of a 529 Plan. The IRS allows you to contribute up to five years, or $70,000, total at once. While you may not be able to afford $70,000 at once, 529s do allow for contributions from other family members like grandparents.
In many, though not all, states they allow for a tax deduction on state income taxes for 529 Plans. The other thing to consider is that plans in some states offer only advisor-led investment options or no tax deductions. In an event like that, Becker adds that the low cost 529 Plans from Utah or Nevada are good options to look at when you’re not getting a tax deduction from your own state’s plan.
Option #2 – Coverdell Educational Savings Account (ESA)
Coverdell ESAs are another great option to consider if you’re interested in saving for college for your child. The Coverdell does not offer the heftiness in contribution limits that the 529 Plan does, but that should not cause you to discount them as an option.
The Coverdell ESA currently allows a contribution of $2,000 per year per child and growth acts just like that in a Roth in that they’re tax-free. The other nicety to Coverdell ESAs is they can be used not only for college, but also qualified K-12 expenses. If you live in a state that does not allow for an income tax deduction for 529 contributions, then a Coverdell can be a good option to consider.
The major drawback to Coverdells however comes in the fact that couples are not allowed to contribute to them if their modified adjusted gross income is over $220,000.
#3 – Custodial (UGMA/UTMA) Accounts
The final main option parents consider for their college savings needs are custodial accounts. Whereas both the 529 and Coverdell are full of benefits, the custodial account is lacking. One of the main drawbacks to consider, according to Becker, is the lack of tax benefits, not to mention harsher financial aid implications.
To make it worse, parents have significantly less control over the funds once the child hits age of majority, as the account becomes the property of the child. This makes the UGMA/UTMA really only beneficial if you simply want to provide your child a monetary gift or have already maxed out both 529 and Coverdell options.
Making Your College Saving Choice
While there are three main avenues to save for college, a rundown of them reveals that there are only two real options for most – the 529 and the Coverdell ESA. This point is even stronger when you consider that both of those options also allow for transferring of plans to other family members if the child they’re originally intended for does not end up attending college.
The question of which plan – the 529 or Coverdell is best for you, becomes a bit more complicated when taking a look at some of the intricacies offered by 529 Plans. In some cases, a 529 Plan may give you the ability to lock-in current tuition rates for future attendance tax-free, otherwise known as prepaid tuition through tuition credits. In many instances, these plans are administered by the individual states (though some schools do offer them directly) and are largely for public institutions, though Becker adds that some private institutions allow for prepaid plans. The other thing to consider is that in nearly every case you lose the ability to benefit from pre-payment if you move out of state.
Assuming you’re not going for prepaid tuition, then either the standard 529 Plan or Coverdell will both work similarly – contribution amounts notwithstanding. Either can be used for college education at public and private institutions. The Coverdell generally has more investment options as you can open them through an online broker, but most 529 Plans offer a wealth of index fund and age-based investment options. When owned by the parent, they both only count as 5.64 percent of your expected contribution as opposed to the typical 20 percent that assets of the child are in the event of them having a UGMA/UTMA account. This makes either the 529 or Coverdell justifiable options to look at, depending on your circumstances.
As With Investing, Cost is Key
Expenses are often overlooked when it comes to investing. Their importance is just as key when it comes to saving for college. According to Becker, “Some 529 plans have high costs associated with them, and that can be a reason to avoid them even if you would get a state income tax deduction for your contribution.” This necessitates taking a look under the hood when it comes to fees. Not every 529 Plan is created equally so expenses must be evaluated.
In some instances, states offer self-directed plans, but in others they are advisor led – which adds cost. On average, the difference between the two can be nearly .50 percent. While that seems insignificant on the surface, that difference will add up over the years. Like Becker said prior, in this event you would want to look at state plans like those offered in Nevada or Utah if your state does not offer a low-cost plan or if you do not receive a tax deduction.
Cost is one area that Coverdell ESAs can tend to stand out. Most online brokerages, as well as a handful of mutual fund companies, offer Coverdells as an account option. This can allow the freedom to choose an online broker that offers no-cost index funds to invest in so that you can keep your costs down.
Keep Your Eyes on the Prize
Saving for college can be overwhelming, but there are two great options to consider in a 529 Plan and Coverdell ESA. Both are distinct in the benefits they offer for both you as the parent from a tax perspective as well as for your child, to fund college. You can also use both plans concurrently, as long as you stay within annual gift tax limits.
It’s also important to remember that there are many ways to help fund a college education – loans, scholarships, grants and more – the key is to formulate a plan that makes the most sense for you and your child so both of you are set up for success, is which the ultimate goal of all your saving efforts.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.