Over the last few posts, I have shared with you several of the items on my New Year’s resolution for 2016: write more (hence this blog), make the proper adjustments to our family budget, get better at photography, take more pictures, start a home business… Although there is plenty of room for me to keep improving in all of these areas, I feel that it is time to start getting serious about next item on the list, my kids college fund.
When I attended college from 2003-2007, I attended a state school, lived at home, worked part time during the semesters, and full time during the summers. While both of my parents are hard workers, neither of them could provide any additional financial assistance besides our home and food, for which I am very grateful. But, it wasn’t easy.
There were semesters when I had to choose which books to buy and which to depend on the kindness of my friends to let me borrow. A couple of times I came close to having all the classes I had registered for the following semester dropped if I didn’t pay the bill for the current semester in full in the next few days (this is a huge deal if you are trying to get into classes you need to graduate that have limited seating).
For a while, to get to school, I drove a car that had no working heating system. That would probably be irrelevant had I gone to school in Texas, but in the frosty New England winters, some days there weren’t enough layers to keep me warm on the 30 minute drive to school and 10-15 minute walk from the parking lot to get to class. No wonder I can’t stand the winter. But I am not complaining… I know a lot of people who had it much worse than I did.
I prayed a lot, worked hard, applied for scholarships, and invested my earnings into my education. In the end, I feel very blessed to have graduated in four years with a B.S. in Biology with minors in chemistry and math DEBT FREE.
Unfortunately, I fear my children will not have the same privilege. Actually, even If I were to go back and try to pay my way through school working the same job I had then, as driven as I am, I highly doubt I could make it very far. That is because the cost of education has dramatically increased over the years, the wages have not.
According to a post on the Wall Street Journal, the students in last year’s graduating class will be paying back an average of $35,000 in student loans. To me, that is absolutely CRAZY, especially considering that this amount is likely well over half of what they will make on their first year of employment, that is, if they get a job right away. And these are just averages, in other words, when you take interest into account, there might be a lot of people paying student loans for the rest of their lives.
I don’t wish that for my children or for yours either.
While setting up a college fund for my children has been on my mind since before they were born, I confess I have been too overwhelmed with the demands of motherhood over the last few years to take that thought a step further. Now, as my oldest approaches his fourth birthday, I realized I cannot wait any longer and I must get it started already.
According to this 2014 article by Catey Hill on Market Watch, based on the current trends in education costs,
“It may cost a child attending a four-year in-state college in 2031 (17 [now 15] years from now) more than $220,000 for all four years and a child attending a four-year private school more than $491,000.”
Wow! If looking at these figures is not enough motivation for me to get started today, I don’t know what is.
I am not a CPA, nor do I have any training in economics or accounting but, I like to research and learn new things, especially when it comes to making financial decisions for my family. As I go through this process of researching, learning, and finding the best way to set up a college fund for my children, I thought this information might be beneficial to some of you so I decided to share it as I go. So, here is what I have learned so far….
There are several ways we can save for our kids’ higher education expenses and some of them are better than others. Check out this list I have put together along with the pros and cons of each.
- General Savings Account
According to an article on marketwatch.com entitled “Parents: You’re Saving For College All Wrong,” in 2014, 45% of parents who are saving for college, are doing it in a general savings account.
Although this method is mostly risk free, it is probably the least effective way to save since the low interest rates currently offered will give you minimal returns on your investment. Not only that, but any returns you do receive will be subject to annual income tax.
- Risk free
- Can be used for any purpose without penalties or restrictions
- Low rate of returns
- If the saving’s account is in the student’s name they may end up losing a substantial amount in financial aid when they fill out their FAFSA
2. 529 Plan
A 529 Plan is a special investment savings account for higher education costs operated by a state or educational institutions. It allows money to grow in two ways, through interest and the fact that you wont have to pay taxes on your earnings if the money is used for qualified educational expenses.
Almost every state has at least one of these plans available and some states even offer residents full or partial tax deduction for 529 plan contributions. In most cases, you do not have to be a resident of a specific state to apply for their 529 plan.
If you are more of a visual learner like me, here is a short video from savingforcollege.com to help you process this information:
There are two types of 529 plans:
Savings Plans: These function similar to your 401K or IRA accounts by investing your contributions in mutual funds or alike. Usually these plans will give you options to choose from and the growth of your money within these accounts will be based on the performance of the option you choose.
Prepaid Plans: these plans will let you pre-pay part or all of the costs of an in-state public college education. This plan is beneficial if you are sure your child will attend an in-state public school. If your child ends up choosing to go to school out-of state, they will get a return on their money but not the full value. Here is an example from an article at Bankrate.com that I found helpful: “if someone bought 1 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.”
- Money grows tax free
- Tax free withdrawals if used for qualified educational expenses
- No income limits
- no age limits
- no annual contribution limits
- Money is considered parent’s asset and has less of an impact on financial aid calculations.
- Money is transferable (if one child doesn’t use all the money in the account, you can change beneficiaries)
- Contributions may be deductible in some states
- Funds may only be used for higher education, not high school or grade school
- Less control of the investments since the plans are handled by managers chosen by each state.
- Although your contributions into the plan will never incur a penalty for withdrawal, the profit you received from interest is subject to income tax and a 10% penalty if withdrawn for unqualified expenses. (for a list of qualified expenses and for exceptions to the penalty rule see here)
- Investments in the plan can only be changed twice a year
- You might not be able to claim American Opportunity tax credit or Lifetime Learning credit when filing your taxes
You can enroll in a 529 plan by contacting a Plan manager directly or through a financial advisor.
If you would like to read more about 529 plans here are some resources I have found useful:
- Name the top 7 benefits of 529 plans
- State 529 Plans
- Top performing 529 plans for 2015
- How a 529 plan will affect your child’s financial aid eligibility
3. Coverdell Education Savings Account (ESAs)
Much like a 529 plan, ESAs are an investment savings account for educational expenses that grows and can be withdrawn tax-free. The main difference between an ESAs and a 529 plan is that in addition to higher education, some K-12 expenses may also qualify when using an ESA.
- Money grows tax free
- Tax-free withdrawals if used for qualified educational expenses
- Money is considered parent’s asset and has less of an impact on financial aid calculations.
- Money can be used to pay for elementary, secondary or college education costs.
- Funds may be invested in just about any type of investment desired.
- If child decides not to attend college, money is transferable to another qualifying family member under the age of 30.
- Law forbids funding once beneficiary reaches 18
- All withdrawals must be made by the time your child reaches the age 30, or it will be subject to tax and penalties.
- $2,000 annual contribution limit which may be adjusted based on your adjusted gross income
- If ESAs are established by different family members for the same child and the total contribution exceed $2,000 in a year, a penalty will be owed.
- You might not be able to claim American Opportunity tax credit or Lifetime Learning credit when filing your taxes so a portion of your ESA withdrawals can become taxable.
Any bank, mutual fund company, or other financial institution that provide traditional IRAs is capable of serving as custodians of an ESA. Your contributions will be invested in any qualifying investments available through the sponsoring institution.
To learn more about ESA’s check out the links below:
- Intro to Coverdell Education Savings Accounts by savingforcollege.com
- 529 Plans vs. Coverdell Educational Savings Accounts. In depth explanation of the differences between the two types of money saving options.
Here is a short video comparing 529 Plans and ESAs
You can be enrolled in both 529 and ESA plans.
4. Roth IRAs
Roth IRAs are designed to help people save money for retirement. You can open an IRA for yourself or on your child’s behalf when they start earning income and, like the two options above, you can make after-tax contributions to the plan and your money will grow tax free.
- Tax-free growth
- money can be used for non-educational purposes
- You can contribute for as long as you earn income
- you can withdrawn your contributions at any time without penalty or tax for any reason (NOT earnings)
- Not counted among assets on the FAFSA.
- A withdrawal of only contributions will have no effect on financial aid.
- If owned by a student will count as asset and affect financial aid eligibility.
- The account must be open and funded for five years before earnings can be withdrawn for a qualified purpose (higher education expenses included) without the 10% penalty.
- Roth IRAs earnings are only tax free if withdrawn after age 59 1/2 even if used for education.
- Only individuals whose modified adjusted gross income doesn’t exceed $132,000 can contribute ($194,000 if you are married filling jointly)
- Annual contribution limit of $5,500 (amount changes if you are 50 or older)
- It will affect your retirement income if the Roth IRA is your only retirement savings account.
It is NOT a good idea to use money from your retirement savings to fund your children’s college education. In fact, you should probably make sure your retirement accounts are being funded BEFORE you start thinking about starting a college fund for your kids.
For more resources on resources on Roth IRA’s see below:
- Roth IRA’s information from the IRS
- Roth IRA 5-Year Rule
- IRS guide to Educational Exception to Additional Tax on IRA Distributions
- 3 reasons to use a Roth IRA to save for college (Article posted on marketwatch.com)
- 529 Plan Trumps Roth IRA in saving for college (Article posted on forbes.com May, 2015)
As you can see, there is a lot to consider when deciding where to keep your money when starting a college fund. I hope you have found this post to be helpful and informative as you make these important decisions for your family.
As for me, after researching and reviewing all the information, I came to the conclusion that it would be best for us to stay away from a general saving’s plan and, since we already use Roth IRAs to save for retirement, the 529 plan and the Coverdell ESA would be the best starting point for our family. To be more precise, I believe we will start with a Coverdell ESA since the state income tax deductions offered by 529 plans do not apply in the state of Texas, I appreciate having more control over the investment, and our contributions will probably not exceed the annual limits for the time being.
The next step in this process would be to figure out which institution offers products with the best returns and the lowest maintenance fees. I guess that could be the topic for another post=D
Once again, I am not a CPA or financial advisor. All I am sharing with you is information that I have compiled and shared here for the sake of starting a conversation on the topic. The choice of which method to use is highly personal and should be based on your specific situation. If you have questions on what method is best for your family, you should probably discuss them with your financial advisor.
Was this information helpful to you? Do you have any information to add? Would you like to hear more about my next step in setting up a college fund? If so, please make sure to let me know in the comments below.
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