How Should I Save for My Child’s Education?
It’s no secret that college tuition costs have been on the rise for decades – a four-year degree at an in-state public school can cost more than $25,000 per year in tuition, fees, books, supplies and room and board. (And double that amount if you’re considering attending a private university.) Fortunately, there are several savings programs available – each with its own advantages and limitations – that provide significant tax benefits while you put money away for college.
529 Plans
Perhaps the most well-known vehicle for education savings is a 529 college savings plan. Any funds you put into a 529 plan will grow tax-deferred, and withdrawals that are used for qualified education expenses are completely tax-free.
The Benefits of 529 Plans
Funds in a 529 plan can be applied to more than just tuition: Books, supplies, computers and even internet access are all eligible expenses if used for education. And despite its name, 529 college savings plans are not just for college – 529 funds often can be used for trade schools, apprenticeships, K–12 education, graduate school and even some student loans. Plus, after you’ve paid for any education expenses, your 529 can find new use: It can be reallocated to another family member for their education or rolled over into the beneficiary’s Roth IRA for retirement.
Other Considerations
- Each state sponsors its own 529 program(s), and details like investment options and plan features can vary from plan to plan. Additionally, some state plans might not conform to the federal tax code, and some expenses may be subject to state tax depending on where you live. Talk with your Baird Financial Advisor to determine if a state plan fits your needs.
- Any funds saved in a 529 plan owned by the parent or student will have a minimal impact when applying for need-based federal aid – just 5.6% of the account is considered available for college. Plans owned by others, such as a grandparent, have no impact on financial aid eligibility.
- Many states offer state income tax deductions or credits for contributions to a 529 plan, depending on where you live and how much you contribute.
UGMA or UTMA Custodial Accounts
Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) accounts are considered custodial investment accounts, similar to a savings account a parent might start for their child. The custodian manages the account for the benefit of the minor until the minor has reached the age of termination – typically age 18 or 21, dependent on where you live.
The Benefits of UGMA and UTMA Custodial Accounts
One unique advantage to these accounts is that the assets can be used for a wide variety of expenses for the benefit of the minor. Tuition, books, and room and board are all eligible expenses, but so are class trips, music lessons and even college transportation costs like airline tickets or gas money.
Other Considerations
- Any assets put into an UGMA or UTMA account are considered an irrevocable gift to the minor and cannot be reclaimed by the contributor or custodian. Also, once the minor reaches the age of termination, they gain complete control over the entire account. Your Baird Financial Advisor is a great resource for initiating conversations around how you can prepare your child to take on this responsibility.
- For higher education costs, sizable savings in an UGMA and UTMA are more likely to trigger a tax liability. Under the kiddie tax rules, the first $1,350 of earnings in the account can be tax-free, the following $1,350 is taxed at the child’s tax rate and additional earnings above that amount are taxed at the parents’ tax rate.
- UGMA and UTMA accounts can have a significant impact on the amount of federal financial aid a student might receive, as they are assessed at 20% of available assets towards college. Funds in an UGMA or UTMA count more toward your available education resources than those in a 529, making it harder to qualify for aid.
Roth IRAs
A Roth IRA is a retirement account in which you contribute after-tax dollars throughout your career, and qualified withdrawals from the account are completely tax-free. While Roth IRAs were designed with your retirement in mind, there are exceptions that can help fund your child’s post-secondary education.
The Benefits of Roth IRAs
Roth IRAs offer a wider variety of investment options than other college accounts, including stocks, bonds, CDs and real estate trusts.
Other Considerations
- There are rules limiting how much you can contribute to a Roth IRA, so it can be difficult to save enough to cover future education costs.
- Even though the account value of your Roth IRA is excluded from the FAFSA, withdrawals from your Roth IRA are reported as income and could negatively impact a future FAFSA application two years after you start withdrawing funds.
- If you’re considering using your Roth IRA to pay for your child’s education, make sure you’re not shortchanging your own retirement. There are many programs and funding vehicles for a college education that simply don’t exist for retirement.
Coverdell ESAs
A Coverdell Education Savings Account (ESA) combines many of the benefits of a 529 plan and an UGMA or UTMA account. It is a type of custodial account, but one that can only be used for educational expenses.
The Benefits of Coverdell Education Savings Accounts
Like with 529 plans, Coverdell ESA contributions grow tax-deferred, withdrawals for qualified educational expenses are tax-free, and you have flexibility around the level of education to which they can be applied. Like the UGMA and UTMA, your investment options for a Coverdell are quite broad. And in certain circumstances, you can change the beneficiary of the account to a qualifying family member. Because this account is considered an asset of the parent, its impact on a student’s financial aid eligibility will be minimal.
Other Considerations
- Like with a Roth IRA, contributions to a Coverdell have an annual maximum – only $2,000 per year – and can only be made until the beneficiary turns 18. The account must be closed after age 30, and any unused savings could be taxed or penalized unless transferred over to another ESA of a qualifying family member under the age of 30.
- On top of the contribution limit, your income level may also reduce or restrict the amount you can contribute. The contribution limits begin to phase out for individuals at $95,000 ($190,000 for married couples), and individuals who make over $110,000 ($220,000 for couples) cannot contribute to a Coverdell.
- For those interested in the increased flexibility that 529s offer, you can roll the assets from a Coverdell into a 529 for your named beneficiary free from taxes and penalty. This is considered a trustee-to-trustee transfer and is a common strategy to extend the life of your education savings accounts.
Brokerage Accounts
A brokerage is a taxable investment account in which you can buy and sell stocks, bonds, mutual funds and ETFs, among other investments. This account has no tax deferral benefits, but you can keep the funds in your name until you are ready to gift the money to your child – and, in the meantime, use the funds any way you like.
The Benefits of Brokerage Accounts
You can withdraw funds from a brokerage account for any reason, at any time, and use them for any expense. Like an UGMA, UTMA or Coverdell ESA, you have control over the investments within the account, and there’s no limit on how much can be saved in the account.
Other Considerations
- As the term “taxable” suggests, a brokerage account offers no unique tax advantages, though there are essentially no restrictions on contributions and withdrawals.
- As long as the account is not in the child’s name, the assets have less impact on financial aid.
Ultimately, how you decide to save for college can have a significant impact on a wide range of wealth management issues, ranging from taxes and cash flow to retirement and estate planning. Your Baird Financial Advisor team has the tools and expertise to navigate every facet of this conversation and help you come to the best decision for your family.
The information offered is provided to you for informational purposes only. Robert W. Baird & Co. Incorporated is not a legal or tax services provider and you are strongly encouraged to seek the advice of the appropriate professional advisors before taking any action. The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.
