They’ve taken the SATs (three times). They’ve gone back and forth on what their major should be and what career path they want to take. They’ve dragged you along on campus visits. And now, they’re waving goodbye as they rush off to orientation.
You’ve blinked your eyes and now your kids are becoming college students. You can’t put a price on their excitement, but you can on the tuition bill you might be left to foot.
Saving for your child’s college education can seem like a daunting task. Unlike with retirement savings, few clear guidelines exist. College costs vary widely depending on where your child goes to school and whether they qualify for financial aid. So how can you afford your child’s dream school, without sacrificing your own retirement fund? The key is to start saving early and identify the savings vehicle(s) that aligns best with your long-term financial goals.
College Savings Plan Options
One of the most common savings vehicles is the state-sponsored college savings plan: the 529. 529 plans benefit over traditional taxable accounts because their investment gains grow and can be withdrawn tax free as long as they’re used for qualifying expenses. Many states also offer additional tax benefits to local residents who invest in their respective state’s plan. While there is no limit on annual contributions, there are lifetime limits that vary by state, which are typically $200,000 or more.
Student Loans & Aid
Student loans offer several long-term benefits and can fill big financial gaps. Yes, loans shift the burden of repayment to your child, but this method also helps them build credit as they pay it back.
There are a few options if you decide student loans and aid are the right route for you:
- Federal Aid
Federal Student Aid (FSA) – part of the Department of Education – is the largest source of financial aid in the United States, offering loans, grants and work study funds. Federal loans have flexible repayment options and competitive rates. They also offer deferments and other features that most other loans don’t. Federal grants can be merit-based, need-based or student-based, and do not need to be repaid. Many factors determine your aid eligibility. While your income (and family income, if you’re a dependent) is one driving force, the cost of the school you’re attending, your year in school, your enrollment status and expected family contribution also matter. The financial aid office at your college will use all of these factors to determine how much financial aid you are eligible to receive.
- Subsidized v Unsubsidized Loans
The federal government pays the interest on a subsidized student loan while the student is in college or if the loan is deferred. Unsubsidized loans accrue interest when the loan begins. There are borrowing maximums, depending on the year in school, including for graduate students. Interest rates and fees vary.
- State Aid
State governments also offer grants, scholarships, work-study funds, state loans and tuition assistance.
- Institutional Aid
Some colleges and universities provide aid to their students through scholarships, grants and work-study programs via institutional aid programs that come from their own resources.
- Private Loans
An alternative to federal loans, especially if you need to borrow a higher amount. However, these loans are more expensive, averaging 9-12% annually.
As always, you should not sacrifice your retirement for your children’s education. You can always borrow for college; you can’t borrow for your retirement. The interest rates for federal student loans – the types of loans your children might take out if they need to – are usually less than what you can make by putting your money in a good long-term investment strategy.
Coverdell Educational Savings
A Coverdell Education Savings Account (ESA) is a trust or custodial account whose sole purpose is to pay for qualified education expenses for beneficiaries under the age of 18 (or special-needs beneficiaries). Formerly known as a low-contribution education IRA, a Coverdell ESA may be used for private K-12 education expenses or qualifying college expenses (tuition and fees, books, supplies, equipment, room and board). While there is no limit on the number of accounts your child may have, there are limits to total contributions. Most traditional mutual funds, exchange traded funds, stocks, bonds or CDs may be used inside of a Coverdell ESA.
Coverdell ESAs enjoy tax benefits similar to a Roth IRA. Money grows tax deferred and may be removed tax free for qualifying expenses, although contributions themselves aren’t deductible. According to the IRS, if an account’s distributions aren’t more than your child’s qualified education expenses at an eligible educational institution (in one year), then your child won’t owe tax on the distributions.
Custodial accounts – aka Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) accounts – are another way to save for college expenses. An adult, such as a parent or grandparent, is the custodian for this type of account until your child reaches the age of majority, usually 18. This means the custodian makes all investment decisions for the account. UGMA accounts can only hold money and securities while UTMA accounts can hold other types of property. As with many of these methods, custodial accounts have distinct benefits and drawbacks. For example, there are no contribution limits (gift and generation skipping taxes aside); however, there is also no tax-deferred growth or tax-free withdrawals. If you start saving while your child is young, this could add up to a large tax bill. Also, if there is a significant amount in these accounts, it could affect qualifications for financial aid.
IRAs offer greater flexibility when saving for college —you maintain full control over the underlying investments. But, this also means they require greater responsibility and may not be ideal for “hands off” investors. You would be responsible for monitoring and maintaining the portfolio allocation over time. This could complicate things because you would be saving for two different timelines, your retirement and college goals.
- Traditional IRAs
These accounts are tax deferred, so money is deposited pretax, and taxes are not due on principal or earnings until withdrawal. While distribution is taxed at your ordinary income rate, you can withdraw money penalty-free at any age for qualified educational expenses, such as tuition, books, fees and supplies.
- Roth IRAs
These accounts are tax exempt, which means money is contributed after tax, but earnings and dividends accrue tax free (though they are subject to early withdrawal restrictions). A Roth IRA may be beneficial if you’re unsure whether your child will attend college or if you want to maintain monetary flexibility. This makes a Roth IRA a great investment option if you’re willing and/or capable of sacrificing its use as a retirement vehicle. It is important to prioritize your own retirement over paying for college – you can get a student loan for college if needed, but there’s no loan for your retirement. Keep in mind, there are investment and income limits to a Roth IRA. If you’re eligible for a Roth IRA, contribute to that account before a 529 plan.
Saving for your children’s education is obviously important, but making sure you are saving for your retirement is equally as important. If you’re confident your child will attend college, max out any retirement account options – such as a 401k (especially if your company matches) or IRA – before you fund a 529 or any other education-specific account. The tax deduction and long deferred growth of retirement accounts tends to outweigh the tax-free growth in your 529 for a shorter period of time. If you’re eligible for a Roth IRA, you should also contribute to that account before a 529. The principal can be pulled anytime, including for education expenses.
Reach out to one of our financial advisors to help determine which plan aligns best with your long-term financial goals.
Personal Capital Education Planning Guide Series
- When to Start Saving for College
- When Does a 529 Make Sense?
- 5 Tips on Saving for College and Retirement
- Three Options When You Have Extra 529 Funds
- Case Study: Funding College While Saving for Retirement
Amin Dabit, CFP®
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