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Guide to Saving for a Child’s Education

October 10, 2018 | Personal Capital

There’s no doubt about it – education can be expensive. The cost of college tuition has risen over the past few decades. In fact, the average tuition for an American private, nonprofit four-year school has seen a 129% increase since 1988.

So, how do you save for your children’s education while also planning for your own retirement? How much can you afford to contribute to your kids’ future without sacrificing your own long-term plans or impacting the legacy you want to leave behind?

There are many options when it comes to saving for your child’s education, but doing so can be tricky to navigate without the proper knowledge and guidance.

Whether you are planning a family or already have one, now can be a great time to address this major financial goal. The Personal Capital Guide to Saving for a Child’s Education can help you learn more about ways to save for your family’s future without sacrificing your own.

Download this Guide as a PDF

*This guide will focus mainly on financing higher education for your children, although tax reform passed in December 2017 means many of these lessons can also be applied to other educational needs.

PERSONAL CAPITAL STRATEGY: HOW MUCH SHOULD YOU AIM TO SAVE?

Not sure what number to put in your plan? A good “average” tuition cost to aim for is $25,000 per year for public schools, and $40,000 per year for private schools. If you have a baby or toddler and you’re saving with a 529, shoot for funding roughly 30% of the expected cost upfront, if you have the funds available. A good starting amount is $28,000, since that will keep you under the annual gifting limit (gifting limits are $15,000 per person per recipient and $30,000 for a married couple per recipient in 2018). You have the option to add more without a penalty, but it complicates your tax situation. If you don’t have $28,000 upfront, start by contributing $250 per month to a 529 account (assuming you have a young child who will be attending a public university).

As your baby or toddler grows into a young child, aim to have 50-70% of the expected cost of the education or your funding goal — continue increasing that amount as your child nears college.

The Personal Capital Education Planner can help you understand and compare college costs, and determine your annual savings needs while you track your progress.

Financing Options – 529 Plans

There are different ways to finance your child’s education, all with different benefits and challenges. You should familiarize yourself with the options and their impact on your taxes and savings.

Since 529 Plans were first established in 1996, Section 529 savings plans have become a popular tool used by parents to save for future college expenses. According to the College Savings Plans Network, the average 529 account size grew 13% in 2017 from the year prior to a record $24,057. In the same year, total investments in these plans reached $319.1 billion – a 16% increase over 2016

The plans continue to grow in popularity as an education savings tool. One reason 529 plans are so popular is the tax breaks they allow. As long as funds are used to pay for qualified education expenses, earnings within the account grow tax free. Also, many states allow full or partial deductions for 529 plan contributions.

How do 529 Plans Work?

Money saved in a Section 529 account can be used to pay for a wide range of different kinds of education expenses. These include not only tuition, fees, books, and room and board, but also computer technology, computer equipment and related services, such as Internet access. Keep in mind, there are specific requirements for each of these types of expenses to be considered qualified education expenses. requirements.

There are two main types of Section 529 plans:

Prepaid Tuition Plans

Prepaid tuition plans lock in a specific amount of future tuition at today’s prices.

This means you could buy four years of college now for your newborn at today’s tuition rate, which is probably much lower than it will be 18 years from now.

Investment Savings Plans

Investment savings plans are more like retirement savings accounts.

They enable you to invest your college savings in stocks, bonds and mutual funds to try to maximize returns. Remember, though, that there’s no guarantee your investments will be successful, so these may be riskier.

For both types of 529 Plans, your child may not be restricted to attending school in the particular state where your 529 plan is opened – or even the United States. Some 529 plans allow funds can be used to pay for educational costs for schools located outside the United States and vocational-technical schools. However, some states may not allow this, so it’s best to contact the 529 provider for their input on the potential use of the funds.

529 Plans & Tax Considerations

Tax benefits on 529 plans vary by state. States like Indiana offer a tax credit, while most others offer an annual deduction on taxable income. Some states — such as California, Maine, and Florida — offer no tax benefits to residents. In these cases, residents should consider plans based on their investment options and fees.

Savings in a 529 plan grow tax deferred and, if used for qualified education expenses, can be removed tax free. Saving for your children’s education is important; however maxing out any retirement account options – such as a 401k or IRA – before funding a 529 plan is likely a better choice. The tax deduction and long-term deferred growth of a retirement account tends to outweigh the shorter time horizon for the 529 account.

529 Plans & Tax Reform

529 plans may be even more attractive thanks to tax reform that was signed into law in December 2017.

The Tax Cuts and Job Act includes a provision that allows 529 plan funds to be used to pay for qualifying elementary and secondary school expenses, as well as college expenses. So, if you plan to withdraw money from your 529 plan to help pay for private elementary or high school expenses, you can now do so without paying a penalty or taxes.

Before the tax reform legislation, any 529 plan withdrawals that were not used to pay for qualified college education expenses were subject to ordinary income tax and a 10% tax penalty on the earnings portion of the distribution. Now, up to $10,000 of 529 funds can be withdrawn per child each year to help cover primary and secondary private school tuition.

Keep in mind that while federal rules are allowing qualifying K-12 expenses with 529 plans, it doesn’t necessarily mean a plan sponsored by your state has adopted the same rules. You’ll want to consult a professional to ensure if the state-sponsored 529 plan you have conforms to the new rules before taking a distribution.

529 Plans vs. Prepaid Plans

Fees vary significantly by plan and tend to cover enrollment applications, account maintenance, program management, and the expenses of underlying investments. Ten-year costs on a $10,000 investment for direct-sold 529 savings plans can vary from around $100 to more than $1,500, depending on the plan and state. Some 529 plans are only sold through brokers, which typically carry higher fees relative to those available for direct purchase.

Overfunding or Not Using a 529 Plans

In most cases, if you are saving monthly or yearly, you may be comfortable aiming for funding 100% of total expected college costs. This way, you can reduce the amount of funding depending on how the markets are behaving and you can reap the benefits of any tax breaks earlier. If you are still concerned about overfunding or not using a 529 plan – or if you are looking to fund the 529 plan with a lump sum – it’s generally recommended that you target a 529 plan for about 70% of the total expected college costs. Then you can supplement the 529 plan with a taxable savings account until you reach the target savings amount. If you’re still concerned about overfunding, you may want to try funding only your child’s first two years of college. Then, you can use a Roth IRA or other taxable account – or your child can take out a loan – to fund the final years.

Remember, many children get scholarships – whether for academics or excelling at extracurricular activities – decide to go to community college for at least one year, or decide to forego college altogether. If your child receives a scholarship, you can pull the equal amount out of a 529 without penalty. If one of your children does not attend college, money can be transferred to another qualified beneficiary to be used for education – and with tax reform, this includes qualified expenses within primary and secondary private school. Qualified beneficiaries include immediate family members, relatives of your immediate family (e.g. nieces, uncles, etc.), in-laws, and first cousins.

Keep in mind, a 10% penalty and ordinary income tax are charged on investment gains for non-qualified distributions. There is no penalty or taxes on principal – you would only pay a penalty on gains that you have deferred for a long period of time.

PERSONAL CAPITAL STRATEGY: 529 PLANS FOR NON-COLLEGE EXPENSES

If you believe you might want to withdraw some 529 funds to help pay for K-12 expenses, you may want to consider opening an additional account within your 529 plan. This will make it easier to keep track of your separate K-12 and college education savings goals and choose the most appropriate investments based on your investment horizon, risk tolerance, and withdrawal schedule.

However, keep in mind that if you withdraw 529 plan funds to pay for K-12 expenses, this could impact your carefully laid college savings plans. Every dollar withdrawn from a 529 plan early is a dollar that won’t be there when your child is ready to start college. So think carefully before withdrawing 529 funds early, even if the money won’t be subject to a taxes and penalties.

To learn more, talk to a financial advisor.

Test Your Knowledge: See How Much You Know About 529 Plans.

Other Financing Options

Student Loans & Aid

While often burdensome, student loans have several long-term benefits and can fill big financial gaps. Loans shift the burden of repayment to your child, which helps them build credit as they pay it back. And they have the potential to protect your retirement, which should always take priority over saving for college. Remember: your children can always borrow for college; you can’t for your retirement.

Federal Student Aid (FSA)

Federal Student Aid is part of the U.S. Department of Education – is the largest source of financial aid in the United States, offering loans, grants and work study funds.

Federals loans have flexible repayment options and universal, 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. Common ones include Pell grants, Federal Supplemental Education Opportunity Grants (FSEOG), and Teacher Education Assistance for College and Higher Education (TEACH) grants. Keep in mind, the financial requirements for this type of aid can be very strict, and it may be difficult to demonstrate enough financial need to qualify for these.

Free Application for Federal Student Aid (FSA)

All students filing for federal financial aid must file the Free Application for Federal Student Aid (FAFSA).

A common FAFSA misperception is that it’s just for low-income families who receive financial aid; however, anyone hoping to use federal student loans for college will need to apply. Regardless of your income stream, if you’re enrolled at least half-time in a school participating in the Direct Loan Program (most schools in the United States), you’re eligible for an unsubsidized Stafford loan – and maybe more. The FAFSA process can open the door to many grants and loans.

State Aid

State governments also offer grants, scholarships, work-study funds, state loans and tuition assistance.

According to the National Association of Student Financial Aid Administrators (NASFAA), almost every state education agency has at least one grant or scholarship available to residents. While these student aid programs generally only apply to state residents attending an in-state school, it’s not always the case. NASFAA’s website can help you figure out which programs are available in your state and their eligibility requirements. And don’t forget, there is a lot of financial aid also available through nonprofits as well.

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.

Usually these applications request much more thorough and personal information from applicants, including any special circumstances that may not have been explained on a FAFSA application. Each institution is different in what they offer, so it makes sense to evaluate these options to see what is available.

Private Loans

Private loans can be a good alternative to federal loans, especially if you need to borrow a higher amount.

However, there are a quite a few drawbacks. Private loans tend to be more expensive, with rates averaging from nearly 4% to more than 12% annually (for comparison, top credit unions may offer members an average private student loan rate of 4.8%). These loans have interest rates and may require a cosigner and carry additional fees.

COVERDELL EDUCATION SAVINGS ACCOUNTS

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).

Coverdell ESA Investments

There are nearly unlimited investment options when it comes to Coverdell ESAs.

Most traditional mutual funds, exchange traded funds, stocks, bonds or CDs may be used inside of a Coverdell ESA. While this may provide opportunity for growth, it’s good to keep in mind that you may end up paying large fees if you work with a commission-based advisor to choose your funds.

Tax Considerations

Coverdell ESAs enjoys tax benefits like a Roth IRA.

Money grows tax free until distributed, and may be removed tax free for qualifying expenses for kindergarten through college (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. Contributions must be made in cash and must be made by the due date of the contributor’s tax return, excluding extensions. Additionally, annual contributions are capped and have income eligibility limits for contributors. See the IRS for more information.

Restrictions

While there is no limit on the number of accounts your child may have, there are limits to total contributions, which is $2,000 in 2018.

In addition, there are income restrictions on contributions. According to the IRS, any individual with a modified adjusted gross income (MAGI) for the year of less than $110,000 or any individuals filing joint returns with a MAGI of $220,000 can contribute to a Coverdell ESA. You also can’t contribute after your child reaches the age of 18, unless he or she is a special-needs child, and they work on a use-it-or-lose-it basis: the account must be fully depleted by the time your child reaches age 30.

CUSTODIAL ACCOUNTS (UGMA/UTMA ACCOUNTS)

When it comes to college planning, custodial accounts – aka Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) accounts – are another way to save for expenses. An adult, such as a parent or grandparent, is the custodian for this type of account until the 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.

Tax Considerations

There is no tax-deferred growth or “tax-free” withdrawals on custodial accounts.

Instead, the account will be subject to taxes as the income (interest and dividends) are earned each year. If you must sell significantly appreciated securities held in the account, again, taxes will be due on any gains. This might mean that if you start saving while your child is young, you could be faced with a large tax bill when you start liquidating assets to cover educational expenses. And while there are no contribution limits to these types of accounts, you will likely need to consider federal gift or generation-skipping transfer taxes.

Restrictions

Anything transferred to a UTMA/ UGMA is considered an irrevocable gift to the minor, which means anything in these accounts will be considered the child’s assets for financial aid.

Child assets are more heavily weighted than parental assets when calculating the maximum financial aid available for college, impacting the potential dollar amount received if financial aid is needed. And while funds can be used to any purpose that benefits the minor, making these more flexible than 529 accounts, the minor beneficiary maintains control of assets once they reach the age of majority in their state, which means they can use the funds for anything they choose – whether that is education related.

IRAs

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 in charge of monitoring and maintaining the portfolio allocation over time.

Traditional IRAs

These accounts are tax deferred, so money is deposited pre tax, 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 your child will attend college or if you want to maintain monetary flexibility. This makes 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.

TAXABLE ACCOUNTS

Like IRAs, taxable accounts offer flexibility because you control the investments. Generally, taxable accounts include individual, joint, trusts, and the aforementioned custodial accounts. Any gains realized in these accounts will be taxed in the year they were earned.

STATE PREPAID TUITION PLANS

Some states allow prepaid tuition plans that sometimes – but not always – let you lock in future tuition rates at in-state public colleges at current prices. The advantage is that you lock in tuition at today’s prices, which can be a huge benefit as tuitions continue to rise, even for state schools. On the other hand, you usually need to pay the current costs of tuition upfront, and since it must be used for in-state public colleges, your child is not allowed much flexibility to choose otherwise. You can lose any potential growth if your child chooses another school or receives a scholarship at a non-applicable school.

SAVINGS BONDS

You may be able to exclude all or a portion of the interest earned on the redemption of eligible Series EE and Series I bonds from your gross income. In order to qualify for the Education Savings Bond Program, you must be at least 24 years old before the bond’s issue date, and eligible bonds must be issued after 1989. You – or your spouse or dependents – must incur tuition and other education-related expenses at qualifying post-secondary educational institutions (i.e. they meet the standards for federal assistance) during the same tax year you redeem the bonds. When you use bonds for your child’s education, he or she can be listed as a beneficiary, but not as owner or co-owner of the bond, and there are income limitations to qualifying.

How Much Do You Have Saved for Your Child’s Education? See How You Stack Up.

Education Tax Credits

There are tax credits you may be able to take advantage of when it comes to education.

Remember, there’s no double dipping – you can only choose one type of education tax credit per year. These credits phase out based on your level of income – check with the IRS for the latest information.

American Opportunity Tax Credit

Annual Tax Credit of up to $2,500/ eligible student

If you or your dependent(s) are working toward a college degree, you can receive an annual tax credit of up to $2,500 per eligible student for the first four years of higher education through the American Opportunity Tax Credit.

Eligibility Requirements

  • Be pursuing a degree or other recognized education credential
  • Be enrolled at least half time for at least one academic period beginning in the tax year
  • Not have finished the first for years of higher education at the beginning of the tax year
  • Not have claimed the AOTC or the former Hope credit for more than four tax years
  • Not have a felony drug conviction at the end of the tax year
Lifetime Learning Credit

Annual Tax Credit of up to $2,000/tax return

Even if you are simply taking a class or two to improve job skills, you qualify for a credit of up to $2,000 per tax return through the Lifetime Learning Credit. There is no limit on the number of years you can claim the Lifetime Learning Credit.

Eligibility Requirements

  • You pay qualified education expenses of higher education
  • You pay the education expenses for an eligible student
  • The eligible student is either yourself, your spouse, or a dependent for whom you claim an exemption on your tax return.

Saving for Retirement & Education

Planning and saving for retirement and your children’s education are common financial goals.

They are also two of the biggest challenges for families today. How do you plan for an unkown future that requires so much upfront planning? And how do you balance the two? Here is some guidance in thinking about these two in tandem.

Prioritizing Retirement

Saving for your children’s education is obviously important. But, 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.

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. When it comes to college planning, 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 retirement investments.

Career Projection & When to Save

Income varies over a career, and there are different strategies and optimal times to save for retirement vs. education. Understanding your projected career and salary trajectory helps in knowing when and how to save. After all, the salary you earned at 24 is likely not the same two decades later.

When looking at different ways to pay for your child’s education, keep in mind that you will most likely earn more later in life. So as your child grows, so will your salary, which can be important when thinking about planning for the entire family. When you are making the most money, this may be the optimal time to think about saving for both your child’s education as well as your retirement.

Determining Your Retirement Goals

Much of all of this is predicated on how you envision your retirement lifestyle. After all, how do you know how much you can put toward your child’s future if you don’t know how much you need for your own? It’s important to understand what kind of retirement you want. Pick a date, track your budget, know your cash flow, and remember to always look at your finances in a “big picture” way.

There is a huge amount of information on education, college, finance, and retirement out there. Avail yourself of what interests you, but don’t let it overwhelm you to the point that you act rashly… or don’t act at all.

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