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How to save for your child’s future education

Bankrate logo Bankrate 5/22/2019 Amanda Dixon
Father and son fishing© @gvalencia04/Twenty20 Father and son fishing

The 18-year clock starts ticking the moment your child is born.

A college degree, despite the rising cost of tuition, remains a major achievement in the modern economy. You are more likely to have a job and earn a decent salary the more education you receive.

Yet many families aren't preparing. Just 56 percent of parents are actively saving for their child's education, according to Sallie Mae, and hold an average of only $18,135. That wouldn't cover one year of tuition, fees and room and board at an in-state public institution, according to College Board.

The outrageous price tag for higher education, coupled with a lack of parental savings and the economic benefit of actually going to college, has led to historic levels of student loans. Many graduates leave school with a yoke tied around their neck, pushing back their ability to buy a house and start a family.

Best tips to save for college

The following are several types of accounts people use to save for their children’s college education. By doing your homework -- and possibly speaking with an adviser -- you’ll have a better sense of where to park the money you’re setting aside for your child’s future.

1. Open a savings account

Some parents prefer to save for their child's education with some kind of transaction account, such as a savings account. According to Sallie Mae, college-saving parents have nearly $4,000 parked in these accounts. But you’ll need to be careful when keeping college savings in a traditional bank account.

"There is an asset protection allowance, or APA, that protects a portion of the parents' assets, based on the age of the older parent," when determining financial aid, says Mark Kantrowitz, publisher and vice president of research at SavingForCollege.com and an expert in student loans and financial aid.

What are the disadvantages?

Because financial aid is determined based on income and assets from prior years, students with sizable savings in their name could end up with a less generous package.

But even if the savings are in your name, you're still losing out. The top five-year CDs on Bankrate offer a yield just over 3 percent, while the S&P 500 has delivered an average total return of 10.7 percent over the past five years, according to Morningstar.

You take on more risk by investing your money. But keeping college savings in a standard savings account or CD may not be helpful if you’re trying to quickly reach your savings goal.

2. Open a Roth IRA

Parents can give a kid a financial head-start by opening a Roth IRA in the child's name once he or she begins earning income.

While children over age 18 retain control of the account, restrictions on Roth IRA withdrawals keep investors from taking earnings out penalty-free until age 59 1/2. There are exceptions to this rule that allow early withdrawals due to certain circumstances (hardships such as a disability) or for specific types of spending (such as purchasing a first home or for qualified education expenses).

Are there any beneficiary restrictions?

A trust in the child's name is another option for parents. However, these plans come with legal and administrative fees parents won't face with a Roth IRA.

3. Look into 529 college plans

Operating in a fashion similar to a Roth IRA, 529 college savings plans allow parents to invest after-tax money into diversified, low-cost stock and bond funds and then withdraw the money tax-free for qualified education expenses.

Some age-based investment packages work like a target-date fund in your 401(k) - contributions are placed in stock-heavy investments when the child is young, then are automatically reallocated to a higher percentage of bonds and even cash as the child nears college age. Workers in some cases may have access to employer-sponsored 529 plans at work.

Are 529 plans tax-deductible?

These plans offer big tax advantages, says Craig Parkin, a regional managing director at TIAA-CREF, the investment organization that administers state-sponsored college savings plans in California, Kentucky and other states.

"The gains on the accounts are tax-deferred, and once the funds are used to pay for qualified tuition expenses, parents will never pay taxes on those funds," he says.

Where can these funds be used?

Money in these accounts can be used for undergraduate or graduate studies at an accredited two- or four-year campus in the United States. Savings in a 529 plan belong to the parent, not the child.

"A 529 college savings plan is considered a parent's asset because the parent is the account owner and they can change who the beneficiary is," Parkin says.

What if your child chooses to not attend college?

While you are taking on an investment risk, such as the fund dropping in value just as your kid enters school, you're also taking another gamble. What if your kid doesn't want to actually go to college? What happens to the money then?

You do have some flexibility.

"If the child says they don't want to go to college, the parents or whoever owns the account can change the beneficiary," says Kelly Campbell, certified financial planner and founder of Campbell Wealth Management in Alexandria, Virginia. "That way, you know the money will be used for education."

Under the new tax law, parents can use 529 plan funds to cover non-college expenses. Savings can be rolled over into an ABLE account that covers expenses for disabled children and young adults. They can also cover a portion of tuition each year (up to $10,000 per beneficiary) for K-12 students attending a private school.

Just keep in mind that some states haven’t made changes to their tax code. You could pay additional taxes and penalties at the state level even though withdrawals are tax-free at the federal level.

If you don't actually use the money in a 529 plan for education, you'll be subject to a similar penalty for early withdrawal from a 401(k). 529 college savings funds can only be withdrawn tax-free for qualified education expenses, including tuition, books, fees, supplies, and room and board. Money spent on unqualified expenses is subject to income tax and a 10 percent penalty on earnings.

Are there any investment restrictions?

There are also restrictions on how money in these plans can be invested. For instance, account owners can switch the investments in their plan only twice a year.

Three in 10 parents use a 529, according to Sallie Mae, with about $5,500 saved. Unfortunately, that's not nearly enough. Financial advisers recommend saving $300 to $400 a month to cover two years of public college costs.

4. Opt for a Coverdell education savings account

These accounts are alternatives to 529 plans. Both 529 plans and Coverdell ESAs allow families to make contributions using after-tax dollars and savings grow tax-free. And for both accounts, withdrawals are tax-free as long as the savings are used to cover certain costs.

One key difference is that Coverdell ESAs offer parents more flexibility in terms of what’s considered a qualified education expense. In addition to tuition for primary and secondary schools, savings from a Coverdell ESA can cover uniforms, tutoring programs and other K-12 expenses without triggering a penalty.

What are the disadvantages?

The biggest downside to Coverdell ESAs is the low contribution limit. Parents can only contribute up to $2,000 per beneficiary per year. Contribution limits for 529 plans vary by program and by state, but allow families to set aside hundreds of thousands of dollars for their children.

Contributions to a Coverdell ESA cannot be made for children over age 18, and all funds must be withdrawn by age 30.

5. Consider prepaid tuition plans

A prepaid tuition plan is an alternative to a 529 savings plan that may appeal to some parents. Designed for parents who are sure that their child will attend an in-state public university, this plan allows parents to simply pay for tuition credits in advance at a predetermined price.

What are the disadvantages?

Prepaid 529 plans retain the same tax, financial aid and parental protections as 529 college savings plans, but without being subject to swings in the stock market.

"The major limitation to a prepaid plan is that if the child decides to go to school out of state, they'll get a return on their money, but they won't get the full value of the plan," says Parkin from TIAA-CREF. "For example, if someone bought one year of tuition at a Kentucky state school for $12,000 and now tuition is up to $20,000, they would get a full year of college. If they decide to go to school in, say, Ohio, they would get a return -- probably $13,000 or $14,000 -- but they wouldn't get the full $20,000."

Are there any beneficiary restrictions?

Like 529 college savings plans, prepaid plan holders can change beneficiaries at any time, but must pay a 10 percent penalty plus income tax on funds used for anything other than college tuition.

"You can have the prepaid plan to pay for tuition and a 529 college savings plan to pay for other expenses," Parkin says.

6. Open an UGMA or UTMA account

If your child doesn't plan to attend college and therefore isn't at risk of losing financial aid, UGMA and UTMA custodial accounts offer standard tax breaks for children under 18.

UGMA stands for the Uniform Gift to Minors Act. UTMA stands for Uniform Transfer to Minors Act.

In these accounts, a portion of the gains is tax-free, part of it is taxed at the child's income tax rate and the remainder is taxed at the parent's income tax rate. Plus, there are no restrictions on how the funds may be used as long as they directly benefit the child.

What are the disadvantages?

The downside of UGMA and UTMA accounts is that parents have less control over how the child eventually spends the money, says Michael Kay, certified financial planner and president of Financial Life Focus, a financial planning firm in Livingston, New Jersey.

"If money is in a UTMA or a UGMA account, it becomes (the beneficiary's) at the age of majority, which is 18 to 21, depending on the state," he says. "There's no legal way to prevent the child from using money that was intended for college or a house to go to Europe."

7. Set up a trust

An educational trust is another option for parents trying to save for their child’s future. A trust can be set up when an individual wants to hold assets on behalf of another person with the intention of eventually handing them over. When an educational trust is created, the terms of the trust indicate that the trust funds should be used to pay for education expenses.

“A lot of times it’s controlling the money so that it can be used for higher education purposes, but also limiting the child’s access so that they don’t spend it irresponsibly,” says Kristian Finfrock, founder of Retirement Income Strategies in Madison, Wisconsin.

A trust can give a beneficiary (the person receiving the trust funds) more flexibility. In addition to paying for school, the trust could indicate that the funds can be used for other purposes. A trust can also be beneficial for individuals who want to transfer assets and minimize their estate tax burden.

What are the disadvantages?

Taxation rules vary depending on the kind of trust you’re setting up. Whoever is passing along their assets could possibly find themselves paying income taxes. Beneficiaries should prepare to pay income taxes on trust fund earnings.

8. Invest in treasury bonds

Savings bonds could be a solid option for parents opposed to taking risks when it comes to saving for their child’s college education. Investments are virtually secure since they’re backed by the federal government.

Interest on new Series EE Bonds and Series I Bonds is tax-free when it’s used to cover qualified education expenses (or the savings are transferred over to a 529 plan).

What are the disadvantages?

While there’s not much to lose by investing in Treasury bonds, there’s also not much to gain in the form of returns. That’s why Finfrock isn’t a fan of relying on savings bonds to cover college costs. What’s more, he says, not everyone qualifies for favorable tax treatment. Indeed, there are income limitations for high net worth individuals.

How much should you save for college each month?

The cost of college is steadily rising, but you might not need to save for the full amount. In order to make saving more manageable, some experts recommend saving only one-third of the expected costs. The remaining two-thirds can be paid over a lifetime through loans, grants and future income.

To determine the set amount, research projected costs of desired public or private school, look at current projections and divide by the number of months remaining until your child heads off to school. Incorporate the amount into your monthly budget.

When should you start saving for college?

As with any investment, the earlier you save, the more time your money has to grow. Some parents choose to start college accounts for their children before they're born, or around their first birthday.

If you haven't started saving and your child is nearing high school or later, there's still value in opening an account. Vanguard reports that by choosing an account with tax benefits, you'll still have time to take advantage of them -- and "be in an even better position" than not saving at all.

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