Saving for a child’s college education is one of the best ways to set them up for success. Anyone who has graduated college with a massive student loan burden will tell you that life is harder when you’re deeply in debt.
But what are the best ways to save for college?
There are a number of ways to save for a child’s education expenses, and the best choice will vary depending on your circumstances. Let’s take a look at some college saving options.
A 529 is a tax-advantaged account, which makes it one of the best ways to save for college. A 529 is like a special savings account designed for education-related expenses. Anyone can open and contribute to a 529, including parents, grandparents, family friends, and other relatives.
When the beneficiary is ready to attend college, they can withdraw 529 funds to cover tuition, room and board, and other educational expenses.
Other qualified expenses include:
- Books and school supplies
- Computers, software, and other technology items
- Study abroad fees
- Up to $10,000 in student loan payments
Qualified expenses include costs associated with both two-year and four-year colleges and vocational and trade schools. However, not everything will count as a qualified educational expense. For example, transportation costs are not eligible, even if traveling on campus.
When you contribute to a 529, you can invest the money so it will grow over time and reap the benefits of compound interest. Many 529 plans let you choose from various investments, just like a 401(k) or IRA.
Plus, most states offer a tax deduction or credit if you contribute to a 529 – but this benefit only applies to states that charge income tax. The following states do not offer a tax break for 529 contributions:
- New Hampshire
- South Dakota
There are also six states that charge income tax and still do not provide a tax break for 529 contributions:
- North Carolina
The downside to a 529 is that the funds must be used for qualified education expenses. If you use the money for other costs, you may have to pay income tax and a 10% penalty. For example, if there are leftover funds in a 529 after your child has finished college, they can withdraw the funds and pay the income tax along with the 10% penalty.
However, you can also change the beneficiary on a 529 to another family member. For example, if you have multiple children and your first child has money leftover in a 529, you can change the beneficiary to the next youngest child.
There is no annual contribution limit to a 529 plan, but there is an aggregate limit that varies depending on the state. The general range is between $235,500 and $550,000.
The Coverdell Education Savings Account (ESA) is similar to a 529 in that you can use the funds tax-free for qualified education expenses.
The annual contribution limit with a Coverdell ESA is $2,000 per child, which is much lower than the limit for a 529. Also, you can only contribute to a Coverdell ESA account if the child is younger than 18, while there is no age limit with a 529.
If you are eligible for a Roth IRA, you can open and contribute to one and use the funds for your child’s college expenses. Contributions to a Roth IRA can always be withdrawn tax-free, and there are no limits on what those funds can be used for.
Roth IRAs also have more investment options than 529s. You can put the money in individual stocks like Google and Apple or in index funds. You may also be able to find funds with lower fees than you can with a 529.
The annual contribution limit to a Roth IRA is also lower than a 529, at $6,000 per year or $7,000 if you’re 50 or older.
Uniform Transfers to Minors Act (UTMA)
A Uniform Transfers to Minors Act account (UTMA) is a trust account where parents can put money for a child’s benefit. The parent will then manage the account and can invest the funds. UTMAs generally offer various investment options; parents can even purchase real estate with UTMA funds.
Money in a UTMA will automatically become the child’s property when they turn 18 or 21, depending on their state. Once they become an adult, the account becomes theirs, and they can use the funds for anything they want.
The downside to a UTMA is that it will have a bigger impact on how much financial aid a student receives. For example, only 5% of the money in a 529 will be counted when calculating the student’s assets. However, 20% of the money in a UTMA will be counted. This can disqualify the student from receiving some types of financial aid.
The benefit of a UTMA is that you can use the funds to pay for anything, not just education-related expenses. If your child wants to graduate high school and start a business, they can use UTMA funds to do so without a penalty.
There is also no annual contribution limit to a UTMA, but parents who give more than $15,000 (or $30,000 for married couples) will have to pay a federal gift tax.
How to Pick a College Savings Account
Choosing from one of the many college saving options can be difficult because there’s no one right answer for every family.
The best way to pick a college savings plan is to meet with a financial planner who can recommend a plan based on your financial situation. They can also help you understand the possible financial aid and tax implications of each plan.
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