The bad news: College tuition is continuing to rise faster than inflation and family income, causing student debt to be a major problem for many new graduates. According to the Federal Reserve Bank of New York, outstanding student loan balances for U.S. students stood at a hefty $1.3 trillion at the end of 2016.
The good news: There are various ways to fund a college education and time is on your side if you start when your child is young.
Just like any financial decision, choosing a college savings plan should be based on your personal situation. It’s important to understand your options and work with a financial advisor to determine which plan is right for you. When evaluating savings plans, consider the following criteria:
- What are the tax benefits?
- Who controls the funds?
- What risk is involved?
- Are there contribution limits?
- Are large contributions subject to gift taxes?
- What are the impacts on scholarship opportunities?
To help you evaluate your options, here are the advantages and drawbacks of the most common college savings plans.
- 529 Savings Plan1
- Advantages: These state-sponsored plans allow parents to save for a child’s education through flexible, tax-deferred investment options. Earnings are free from federal taxes and most state taxes if used for qualified higher education expenses. Money saved in a 529 account can be used for any accredited two- or four-year college, university or vocational school. A major benefit of a 529 plan is that the account can be transferred to another family member if your child decides to not attend college.
- Drawbacks: Funds in a 529 savings plan can only be withdrawn tax-free for qualified higher education expenses. Money spent on any other expenses is subject to income tax and a 10% penalty on earnings. These plans also carry restrictions on how you can change your investments. Portfolio allocations may only be changed once per year or upon a change in beneficiary.
- Coverdell Education Savings Account (ESA)
- Advantages: A Coverdell ESA is a trust or custodial account used for education expenses. Earnings in this type of a savings account are free from federal taxes when withdrawn for qualified education expenses. This account is unique in that it allows for funds to be used for either qualified higher education or qualified elementary and secondary education expenses. Unused assets can be rolled over from one Coverdell ESA to another, or the designated beneficiary can be changed.
- Drawbacks: This type of savings plan places limits your contribution per beneficiary to no more than $2,000 per year. Like a 529 plan, earnings not used for qualified education expenses are taxed and subject to a 10% penalty. You should also take your current and projected future income into account when evaluating this plan. You will be prohibited from contributing to a Coverdell ESA if your modified adjusted gross income is above the limit set for a given tax year. For 2017, if your income is $110,000 or more ($220,000 or more if filing a joint return), you can’t contribute to anyone’s Coverdell ESA.
- UGMA and UTMA Custodial Account
- Advantages: Although these custodial accounts are not specifically created for college funding, they can be a good way to build a savings in your child’s name. These accounts typically allow a variety of investment choices including stocks, bonds and mutual funds. Although a certain amount of the earnings will be taxed, it is at the child’s reduced tax rate rather than the parents’. Unlike a 529 plan and Coverdell ESA, the money isn’t limited to only higher education expenses, but rather can be used for anything related to the child.
- Drawbacks: The money in either of these accounts is controlled by the custodian only until the minor reaches the age of majority, then the child can legally access the funds. Therefore, there are no restrictions to guarantee the savings will be spent on a college education.
- Roth IRA
- Advantages: This type of account is typically used to build a retirement income, but it can also help to cover the costs associated with college. Withdrawals from Roth IRAs are exempt from the 10% penalty tax if the funds are used specifically for qualified educational expenses, including tuition, fees, books and room and board. The biggest benefit with this type of college savings plan is flexibility. Roth IRA balances can be used for any expense, not just higher education, if plans or your situation changes in the future. Funds leftover after paying for college can be converted to retirement savings without any tax consequences or penalties.
- Drawbacks: Earnings in a Roth IRA are taxable for those under the age of 59. There are also annual contribution limits. For 2017, the total amount you can contribute to a Roth IRA is $5,500 if you under the age of 50 and $6,500 for people 50 and over. People with high incomes are also prohibited from using this savings plan. You can find the updated income limits for a Roth IRA on the IRS website.
- As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also a risk that these plans may lose money or not perform well enough to cover college costs as anticipated. Most states offer their own 529 programs, which may provide advantages and benefits exclusively for their residents. Investors should consider, before investing, whether the investor's or the designated beneficiary's home state offers any tax or other benefits that are only available for investment in such state's 529 college savings plan. Such benefits include financial aid, scholarship funds, and protection from creditors. The tax implications can vary significantly from state to state.
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