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College Savings Strategies: How to Secure a Bright Future for Your Child

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Depending on your child’s age, college may seem like a lifetime away, especially if you are the parent of a newborn. The younger your child is, the more likely saving for their college education is not exactly high on your personal list of parental priorities, but it should be.

Thankfully, there are a number of ways to get started toward saving for your child’s college education right now, which can potentially save money for you and your child by avoiding excessive loan debt in the future. And, like we always say here at Educounting.com, it’s never too early to start saving money, so why would it be any different when it comes to preparing for your child’s college education?

This post will outline some of the most common approaches to saving money for your child’s college education so that you can choose the best college savings strategy for you and your family.

Hang tight because we are going to teach you the ins and outs and the pros and cons of the following college savings options:

  • 529 College Savings Plans
  • Traditional Savings and Checking Accounts
  • Roth Individual Retirement Accounts (IRAs)
  • Coverdell ESAs (Education Savings Accounts)
  • Savings Bonds and CDs
  • Trusts

When you become a parent, it may seem like there aren’t enough hours in your day. However, the earlier you establish a college savings strategy for your child, you’ll discover that time may actually be on your side for a change.

There is no doubt that building your child’s college savings can be challenging. After all, it is reported that the average yearly tuition cost is somewhere in the neighborhood of $9,000 for state residents attending public universities and over $31,000 for students attending private schools. When you multiply that with the number of years it might take your child to earn their degree and factor in other costs such as food, housing, and transportation, you’re looking at a small fortune.

We’re pretty sure that none of this is a surprise to you. Everyone these days recognizes the role that mounting student loan debt plays in the lives of Americans. You might even have personal experience with student debt yourself. No one wants that for their children. Of course, scholarships and part-time jobs may be able to help offset the cost of your child’s education, but the only thing that you can bank on moving forward is the money you save for your child’s future.

How much should you save for your child’s college education?

When you consider a strategy for college savings, the first thing you’ll need to do is take a close look at all of the numbers. It’s safe to say that college costs will continue to grow, so you might consider saving enough money to pay $50,000 annually for college over four years once your child turns 18. If your child is still in diapers and if you can swing $500 per month right now, earning approximately 5%, that may do the trick. However, that might be a lot of money for you, so save what you can, but by all means, start saving now. You can use this handy calculator to help you play out different scenarios, massage the numbers, and get started today.

As you know, it can be a pretty long road to get from diaper to diploma. Still, when you commit to a solid savings strategy early, making smaller contributions over longer periods of time, your child can reap the success of your savings strategy later on down the road.

Here are several college savings strategies that can help you to meet your savings goals and put a good college savings strategy in place for your child before it is too late.

529 College Savings Plans

529 college savings plans are hands-down the most widely-used education-specific savings plans available to parents who want to save money for their child’s future college education expenses.

There are generally two types of 529 plans.

The first type of 529 plan is known as a 529 investment savings account, which allows the account holder to invest money in mutual or exchange-traded funds. These plans obviously carry the same risks and returns associated with other investment accounts that are stock- or bond-based.

The second type of 529 plan is what is commonly known as a pre-paid tuition plan. These pre-paid tuition plans are exactly what they sound like. They give parents the ability to lock in the cost of tuition for their children at today’s rates, allowing them to avoid ever-increasing higher education costs.

The next section of this article will break down each of these 529 plan options.

529 Investment Savings Accounts

A 529 investment savings account will allow you to put away after-tax financial contributions, which will continue to grow tax-free. These accounts are quite similar to Roth IRAs but offer much higher contribution limits. Proceeds from these accounts may be utilized for qualified expenses related to your child’s secondary education, like college tuition, books, and payments for room and board. These proceeds will not cover general living expenses associated with college, such as purchasing a vehicle, for example. Any nonqualified expenditures from the 529 investment savings account will ultimately have tax consequences and will also accrue a penalty of 10%.

While some investment brokers might try and convince you to invest in a 529 plan from a certain state, always check your home state’s 529 program first. Proceeds from these savings accounts may be used for any qualified educational expenses at any college, not just colleges within your home state. Often, state residents get tax breaks and/or matching funds as an incentive for buying into the state’s 529 plan.

Also, keep in mind that you will likely have to pay higher fees when you purchase your plan through an investment broker, though you will, of course, benefit from the broker’s investment guidance. While that is certainly valuable, it is not necessary to use an investment broker to open a 529 savings account. Often, a 529 plan purchased directly from the state will have lower fees. The state’s website will often allow you to choose a pre-determined investment plan based on your child’s age, which adjusts over time, maximizing your savings and managing your risk.

Click here to watch a great video we created about 529 investment savings plans.

529 Pre-Paid Tuition Options

The average college tuition increases at an average rate of five percent annually. With a 529 pre-paid tuition plan, you can actually lock in your child’s tuition costs at a much lower rate. This is basically achieved by paying all or some of your child’s tuition costs in advance to attend a particular school or, in certain cases, a number of schools that are participating in the plan, helping you to avoid the negative effects of future rate increases.

Increasingly, restrictions are being placed on existing pre-paid tuition plans as concerns continue to grow over their future viability. Unfortunately, colleges and universities have realized that this is such a great deal for students, but not so much for them, that many have terminated pre-paid tuition plans. While others have closed the programs to new students.

Pros of 529 Savings Options
  • A 529 savings plan offers high contribution rates, typically without age restrictions or income limits. Contribution limits often vary from state to state but usually allow up to as much as $300,000 in total lifetime contributions.
  • A 529 savings plan offers beneficiary flexibility. Plans may be initially designated for your child but can later be changed to benefit another family member’s college expenses, including your own, should the child not need the money.
  • A 529 savings plan offers tax-free growth.
  • A 529 savings plan is a parental asset as long as you are the 529 account holder, which means it may have little to no impact on any financial aid the child might be eligible for in the future (make sure to review the financial aid application).
  • Some 529 accounts can be used to pay for primary education at private schools as well as college.
Cons of 529 Savings Options
  • Because a 529 plan is strictly for educational expenses only, should the child choose not to attend college or gets a full scholarship and doesn’t need the funds, the money can become unavailable unless you pay taxes and penalties. Of course, you can always change the plan’s beneficiary.
  • Because a 529 plan is essentially an investment account, exposure to the stock market can negatively impact funds. That is especially true if we are in a down market when you tap into the funds. That means that it is important to keep an extra close eye on risk, particularly as the account’s beneficiary nears their financial need. Speaking of stocks and bonds, check out this great podcast from Mak & G where they discuss the subject in greater detail.

Other Savings Choices Do Exist

While a 529 investment savings plan remains the most popular way for parents to save for their child’s educational expenses, other choices exist. This next section will review those choices and break down their advantages and disadvantages.

Traditional Savings and Checking Accounts

It is estimated that some two-thirds of parents in the United States use traditional savings and/or checking accounts as a way to put aside funds for their child’s college education.

Although these accounts provide little interest, they do offer great flexibility. These types of accounts make it easier for parents to tap into them to cover expenses that are not college-related. However, that’s not always a good thing. Even with good intentions to replenish the accounts later, you run the risk of ending up with a depleted college fund.

Pros of Traditional Savings Accounts
  • With traditional savings accounts, there is greater spending flexibility.
Cons of Traditional Savings Accounts
  • With traditional savings accounts, there is little to no tax benefit and very low returns that are usually well below the inflation rate.

Individual Retirement Accounts (IRAs)

When you use an Individual Retirement Account (IRA) as a retirement account and education savings vehicle, you reap numerous benefits and enjoy greater flexibility. Contributions to either a traditional or Roth IRA grow tax-free which gives you have the opportunity to enjoy maximum growth. In addition, you can also invest in an a wide variety of investments, with or without an advisor.

What’s awesome is that all withdrawals from Roth IRAs are penalty-free and also income tax free when used for qualified education expenses. However, funny enough, they are generally factored into income when determining eligibility for financial aid. However, you will have to pay taxes on withdrawals from a traditional IRA as income.

Pros of a IRAs
  • One of the greatest perks of a traditional or ROTH IRA is that if your child doesn’t need the money for college, for whatever reason, your retirement savings can remain invested.
Cons of IRAs
  • With either traditional or ROTH IRAs, there are contribution limits and income restrictions. Furthermore, tapping your IRA for education expenses can hinder your retirement savings strategies, so be sure to proceed with caution and keep a watchful eye over all your savings goals. We love our kids, yes, but we don’t want to submarine our beautiful retirement years.
  • ROTH IRAs when used appropriately will not increase your tax burden. It’s a ROTH account.  But, if you have a traditional IRA, you may have to pay taxes on investment earnings.

If you’re a little unclear about what an IRA is, check out this video on IRAs.

Coverdell ESAs (Education Savings Accounts)

Think of an ESA as a 529 savings account with training wheels.

With an ESA, qualified education withdrawals are still tax-free, and, like IRAs, an ESA offers a wide range of investment options, which are usually more than most 529’s. However, contributions are capped at $2,000 a year and can only be made until the beneficiary is 18. There are also income limitations as well, which is different from a 529.

Pros of an ESA
  • An ESA offers a wide range of investment opportunities along with tax-free growth.
Cons of an ESA
  • Changing beneficiaries associated with an ESA account is not as straightforward a process as a 529 savings account, and options can vary based on the account’s custodian (the financial firm that hosts the account). In addition, all ESA assets must be distributed by the time the beneficiary turns age 30.

Savings Bonds and CDs

With today’s low-interest rates, CDs (certificates of deposit) and savings bonds continue to lose popularity. However, for conservative contributors, laddering these investments (buying various bonds or CDs that will mature in sequence so money is there to help pay expenses throughout a child’s college career) may still be a good option, at least in covering a portion of your savings goals. These investments also offer cash flow flexibility since the portfolio won’t mature all at once in the future.

Series I and EE savings bonds feature education tax exclusions, allowing the exclusion of interest paid from gross income when the bonds are redeemed for qualified education expenses, although there are certain restrictions. I started to save some money with savings bond, but quickly realized the return, even with the tax benefits wasn’t really beneficial.

Pros of Savings Bonds and CDs
  • Savings bonds and CDs offer investment flexibility.
Cons of Savings Bonds and CDs
  • With savings bonds and CDs, there are few tax benefits and generally low returns.

Trusts

Trust accounts were the preferred way to save money for a child’s education long before we had 529s and ESAs. These trust accounts have assets transferred to the child’s account and invested on their behalf until the child reaches the “age of trust termination,” which is usually between 18 and 21, depending on the state where you live.

Here’s the catch: Once the child reaches adulthood, they can use the money for whatever they want, which not a persona preference even for Mak & G. That means they can choose to buy a sports car rather than pay for college. Also, because the assets are in the child’s name, the account value will affect their qualification for financial aid.

Pros of Trusts
  • With a trust, the child has the flexibility to use proceeds from the account for anything, not just college-related expenses.
  • There are tax advantages available to the parent or other trust donor.
Cons of Trusts
  • With a trust, the child has the flexibility to use proceeds from the account for anything, not just college-related expenses. See what we did there? That wasn’t a mistake. The flexibility of a trust account is truly a double-edged sword.
  • There is no way to change the account’s beneficiary with a trust account.
  • Plus, they can be expensive to set up and manage. Do you really want the fight when they get the proceeds and they want to buy a hot air balloon because it’s “cool”?

When Saving Money for Your Child’s Future, Employ a Combination of Savings Strategies

While 529 accounts have become the favored way to save for college, thanks to their tax efficiency and flexibility, the right answer for most parents is to combine several different savings account options to create the best college savings strategy for you and your child. Plus, everyone’s financial situation is different from state tax rates, to available cash now, to how much a family has in their IRA.

A combination of a 529 plan and a Roth IRA account works well for some people, while an ESA combined with a UTMA works for others. At the end of the day, it will all depend upon your long-term savings goals, how many potential beneficiaries there are in your future, and, of course, your and your family’s income and tax situation.

The key, as we have stated repeatedly, is to start early. Starting early will give you more savings options, and always remember that saving for your child’s future college education can and should be a family affair. Often, grandparents, aunts, uncles, and other close relatives, even crazy uncle Tom.  Plus sometimes you may have friends who want to jump on the band wagon. Hey, maybe some of them will be happy to utilize their gift tax exclusion by contributing to your child’s college fund. It is a great gift idea for birthdays and other important milestones, and it’s always better than receiving a pet iguana, right?

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