You might remember my recent blog, “Financial Planning for the New Parent.” In it, I mention college savings as one of the first things to address when you learn you are expecting a child. Because let’s be honest, the cost of education is likely going up and you need to be prepared.
My personal hope is Baby Z is either a scholarly genius or a pro-athlete. That would help with the goal of a full tuition ride. (No time like before your child is even born to start applying the parental pressure).
Here are a few strategies you can implement to start saving for your child’s college education.
Savings Option 1 – Save in the bank or an investment account
It’s perfectly reasonable to save for college in your bank account or in a personal investment account. You’re saving, and that’s what matters most.
The good news about this strategy is the money is liquid and readily available. If you need it, you can get to it.
The bad news is the money is liquid and available. It may be tempting to access this money to pay for other household expenses. The problem is once it’s spent, it’s gone.
Another disadvantage about this strategy is you will not have tax deferral or tax free income that may be available with other college savings options.
Savings Option 2 – A Coverdell Savings Account
A Coverdell savings account allows you to save up to $2,000 per year per child into an education account. This money grows tax deferred. If used to pay for a qualified education expense, withdrawals will be federal tax free.
Coverdell’s allow for greater investment flexibility as compared to a 529 plan (next option on the list). It can also be used for high-school and other non-higher education schooling.
A downside to a Coverdell is it needs to be distributed or rolled to a new account by the time the child is 30 years old and there are income eligibility limits for contributing.
Saving Option 3 – A 529 Plan
A 529 plan is the most discussed college savings option. With a 529 plan, the money you invest grows tax deferred. If used for qualified higher education expenses or tuition for elementary or secondary schools, all the earnings can be withdrawn federal tax free and sometimes state tax free. What is a qualified expense? It includes tuition, room and board, books, and fees. Basically it encompasses necessary expenses a student would incur when enrolling in school.
529 plans provide a lot of flexibility in terms of the use of the money, who it can benefit, and what school the student can attend. The maximum account balance for the same beneficiary of a 529 plan is typically around $350,000. Please check your specific plan for balance/contribution limits.
Keep in mind, if your child does not use the money for college, or the money comes out as a non-qualified distribution, you may be subject to ordinary income and penalties.
Savings Option 4 – A ROTH IRA
A ROTH IRA may be an option for the flexibility they provide an investor. Contributions to a ROTH IRA can be withdrawn and used for any number of needs (including college).
The important word here is contributions. In this strategy, only the contributions should be considered available to pay for college. The investment growth over your contributions should stay in the account until at least age 59.5, or be subject to tax and penalty (potentially). And if you spend it for college, it won’ be available for retirement.
Savings Option 5 – A permanent life insurance policy
A good friend of mine recently sent me a strategy that uses permanent life insurance as a means to fund college education.
While I admit I generally don’t recommend permanent insurance as an investment (more on this topic in a future post), my job here isn’t to sway you one way or another. My job is to educate you on the options.
This strategy directs college savings into a permanent life insurance policy in lieu of the options mentioned above. The insurance policy accumulates cash value that can be accessed to pay for college at the appropriate time.
The good news is cash value may accumulate in the insurance policy that can be used to pay for college. In addition, a death benefit will be paid if you die prematurely, thereby funding college.
The bad news is that the cash value is not guaranteed, life insurance has additional expenses, and permanent insurance is significantly more complicated than the other available options. Proceed very carefully.
What is right for you?
Unfortunately, there is no magic bullet. What you decide will depend on you and your family. There are many factors to incorporate into your decision making, both financial and personal.
Personally, I am a big believer in a ROTH IRA and a 529 plan. Or, I may just start those golf lessons early….fingers crossed for the next Rory McIlory-Zajac.
Participation in a 529 College Savings Plan (529 Plan) does not guarantee that contributions and investment return on contributions, if any, will be adequate to cover future tuition and other higher education expenses or that a beneficiary will be admitted to or permitted to continue to attend an institution of higher education. Contributors to the program assume all investment risk, including potential loss of principal and liability for penalties such as those levied for non-educational withdrawals.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.
An investor should consider, before investing, whether the investor’s or designated beneficiary’s home state offers any favorable state tax treatment or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Consult with your financial, tax or other adviser to learn more about how state-based benefits (including any limitations) would apply to your specific circumstances. You may also wish to contact your home state or any other 529 college savings plan to learn more about the features, benefits and limitations of that state’s 529 college savings plan. Furthermore, the Tax Cuts and Jobs Act that was signed into law on December 22, 2017 allows for up to $10,000 a year per beneficiary in tax free distributions from a 529 Plan if used for tuition incurred for enrollment or attendance at a public, private, or religious elementary or secondary school. Check with your state’s guidelines prior to withdrawing the funds.
For more complete information, including a description of fees, expenses and risks, see the offering statement or program description.
Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).