Last week, Monica started in the toddler room at daycare. And while we’re several years away from paying for college, we also started to make some progress on her college savings fund. Up to this point, any money given to Monica sat in her savings account, accumulating a few pennies of interest income at a time. It was time to put these funds to work. Here are several ways to start saving money for college, in addition to what we chose.
One of the most popular ways to save money for college is through a 529 plan, named after Section 529 of the Internal Revenue Code. The 529 plan is a tax-advantaged savings plan sponsored by states, state agencies, or educational institutions. Earnings on withdrawals for qualified for higher education expenses are exempt from federal and state taxes. Additionally, if you invest in the state 529 plan where you are a resident, there may also be a state tax deduction (subject to recapture under certain circumstances, check your plan document to be sure). There are two types of 529 plans: college savings plans and pre-paid tuition plans. This chart from FINRA does a great job comparing the two:
Spoiler alert: We live in Illinois and chose to go with Bright Start, an Illinois 529 college savings plan. Bright Start is a bit more DIY, in comparison to Bright Directions which is an Illinois 529 plan available through investment professionals (which has higher fees). Another option was to invest in a 529 plan from another state (for example, Vanguard has a 529 plan through Nevada), but then we would lose any tax advantages from being an Illinois resident.
Another benefit of the 529 plan is that anyone (parents, grandparents, other relatives, etc.) can contribute to the plan up until the account value reaches $350,000 per child (at least in Illinois). There are some nice gift and estate tax benefits in doing so (as of September 2014):
- Contribute up to $14,000 ($28,000 for married couples) per student each year, or up to $70,000 ($140,000 for married couples) prorated over a five-year period to someone’s existing account, without incurring a federal gift tax.
- Grandparents, relatives and friends can open their own 529 plan for a student, contribute $14,000 ($28,000 for married couples) per student each year, or up to $70,000 ($140,000 for married couples) prorated over a five-year period, and not incur a federal gift tax.
- Contributions to 529 plans are also excluded from an account owner’s estate when taxes are assessed
Some parents are concerned about the penalties if the funds aren’t used for college, so if you have multiple children, you can always change the account beneficiary. So if Sibling A doesn’t go to college, you can designate the funds for Sibling B’s use.
UGMA/UTMA Custodial Accounts
The Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) are types of custodial accounts that are set up by an adult on behalf of a minor. All of the money in these accounts is turned over to child once they reach the age of majority (18 to 21, depending on the state in which the account was opened) and they can use the funds in any way they choose. You can contribute $14,000 per year, per child without incurring a federal gift tax.
There are a few benefits to UGMA/UTMA custodial accounts, mainly the multitude of investment options and no limitations on contributions. However, unlike the 529 plan, UGMA/UTMA custodial accounts are not tax-deferred and the overall taxation can be a little tricky. The first $950 of earned income from investments in a UGMA/UTMA is generally tax-exempt. The subsequent income up to $950 is generally taxed at the child’s rate. Any income earned over $1,900 is generally taxed at the parent’s rate.
And then there’s the whole control issue. Once the child is a legal adult, they can do whatever they want with the investments. So while you may have hoped your child would use the money for college, there’s no guarantee they’ll be responsible with the funds.
You can also put money away for college in a brokerage (investment) account with somebody like Fidelity or Vanguard. This gives you the most investment options (like mutual funds or individual stocks) and control over the assets. Plus, there are no contribution limits. But then you’ll have to pay federal and state taxes on the earnings each year.
Your Roth IRA
Yes, a Roth IRA account is generally used to save for retirement, but you can pull out your contributions to pay for college and just pay the tax on any gains. And keep in mind, you can only contribute $5,500 to a Roth IRA per year (or $6,500 if you are over the age of 50).
Sure, you can always put money away for college in a savings account, but the returns are very very low. Though one benefit of checking accounts, savings accounts, money market deposit accounts, and certificates of deposit is that they’re covered by the FDIC, up to $250,000 per depositor, per insured bank, for each account ownership category.
While saving for your child’s college education is extremely generous, it’s more important to save for your own retirement first. There’s no guarantee your child will go to college, but I’m pretty sure you’ll want to retire one day. Plus, students have several options in paying for their college education: student loans, work-study programs, scholarships, community college and then 4-year school, etc.
Overall, our current focus is to save for our retirement and pay down our mortgage. When we met with our insurance agent to purchase life insurance, he gave us some excellent advice: work on paying off our mortgage (and any additional debt) now. While our mortgage interest rate is 4%, we’re at the point in our loan amortization where about 50% of our monthly payment goes towards interest. Ugh. And that’s even with additional principal payments. As we continue to make larger than scheduled principal payments, and the occasional lump sum payment, our mortgage will shrink and we’ll have less interest to pay. Right now, if we follow the amortization schedule we’ll be done in May 2037 (yikes!). If we just make our additional principal payments of $231 (and no lump sum payments), we’ll be done in August 2031. When Monica is 18. And about to enter college. (eek!)
If you’re interested in setting up a college savings plan for your child or create a comprehensive financial plan, I’d love to work with you!