Top 3 Ways to Save for a College Degree
One element that makes saving for college more challenging?
The ticking time clock.
Parents and students have about 18 years to save over $100,000, and that number still might include taking out loans depending on the college, degree program, and time it takes to graduate.
As the adage goes, when it comes to saving for college, the earlier the better.
Creating an education plan when your kids are young will give your investments the resource they need most – time. You’ll have more time for your money to compound and more time to make a plan to fill in any potential funding gaps.
Open a 529 Plan
529 plans got their name from Section 529 of the Internal Revenue Code, added in the late 1960s to offer tax-free payments for qualified education expenses.
It’s now one of the most popular college savings avenues and all 50 states have at least one type of 529 plan. There are two categories of 529s:
- Prepaid tuition plans
- College savings plans
Prepaid tuition plans aren’t as common, but they allow you to save for tuition at a specific rate for an in-state public institution. There is a program specifically designed for private colleges as well. Prepaid plans are a good option if your state has excellent public universities and you are sure you’re not interested in paying for private college. One caveat: you may pick this option before being aware of your child’s special talents or special needs, so it does limit your options.
Much more common is the college savings plan, which acts as an investment account for education savings. Contributions are made after-tax, funds grow tax-free, and qualified education expenses (like tuition, room and board, books, computers, etc.) remain tax-free. Funds in this type of account are available to spend at any college, including junior colleges, as well as a wide range of non-college vocational programs.
It’s important to note that making an unqualified withdrawal causes a 10% penalty and income tax on the portion attributed to investment growth from distribution – which is not a winning combination and should be avoided.
The IRS also allows up to $10,000 per year for K through 12 education, and there is a lifetime $10,000 maximum that can be used for tax-free student loan repayment. Not all states allow 529 funds to be used for K-12 purposes, so check with your financial advisor for more information.
When you open a 529, you invest in certain portfolios (mostly mutual funds) while some 529s offer index funds, CDs, and more. Similar to a 401(k), you can select investments based on your risk tolerance and time horizon. To avoid extraneous costs, watch out for investment fees when selecting the right plan for you.
Since 529 plans are state-operated, each could look different regarding investment options and flexibility. Some states offer low-cost options, while other states contract with investment firms who charge high fees on their investment options.
- You can open a 529 in a state you don’t live in. This could expand opportunities to find a plan that will work best for your family.
- Some states offer incentives like tax credits or resident deductions to open a 529, but that’s not the case everywhere.
- You can also use 529 funds to pay for school in a different state. Let’s say you live in Pennsylvania, open an Alabama 529 plan, and send your child to school in Texas – all doable so long as the institution is eligible.
Another 529 perk? Multiple people can contribute to it. Should grandparents or other relatives wish to support your child’s education, they can directly contribute to the account. This provides a welcome avenue for family members to get involved. For example, maybe one year for a holiday or celebration you can ask for 529 donations in lieu of other gifts.
A 529 plan is also a great way to set up recurring investments. If you invested $500 per month into the account, in 18 years you could be looking at a sizable return.
Consider a Roth IRA
Roth IRAs aren’t only for tax-free perks in retirement, they can also be used to save for college. Similar to a 529, contributions are after-tax, funds grow tax-free, and qualified distributions remain tax-free.
Unlike 529s, Roth IRAs offer a wide array of investment options. You aren’t stuck with rigid and costly mutual funds. Instead, you and your advisor can construct allocations that are better suited and tailored to your goals (plus lower fees never hurt anyone).
Another bonus is you can always withdraw contributions to a Roth tax-free. Under certain conditions, you are also allowed to withdraw earnings from a Roth as well. Normally, if you withdraw earnings from a Roth IRA before age 59 1/2, you pay a 10% penalty. Fortunately, withdrawals of earnings to pay for college expenses can be made without penalty – as long as the funds have been in the account for at least five years. So a Roth can be a good vehicle for college savings if you start investing early.
Let’s look at an example.
Say you invest $6,000 into your Roth IRA. Over three years the balance grows to $7,100 (using an average of 6% return per year). If you are under age 59 1/2, you can take out your $6,000 tax-free, but anything over that number is earnings and will be subject to taxes and penalties. If, on the other hand, your investment was made more than five years before, you can take out the entire balance penalty-free as long as you are spending it on qualified education expenses.
But Roths aren’t all sunshine and roses. There are some important limitations to consider.
Roth IRAs have smaller contribution limits – $6,000 per year – as well as income limits for contributing. Should you make too much to contribute directly, you could consider a Roth conversion, meaning converting money from a traditional IRA to a Roth IRA. While you pay taxes on the conversion, you aren’t limited on how much you can convert. You might only be able to contribute $6,000 in a year but, theoretically, you could convert $60,000.
If you’re looking to obtain financial aid, a Roth IRA might not be the account for you. Generally, Roth distributions are considered income on the Free Application for Federal Student Aid (FAFSA) form, which could jeopardize your student’s eligibility for federal aid.
Look Into a Custodial Account
A custodial account is a savings vehicle established and managed on behalf of a minor. There are two general types:
- Uniform Transfers to Minors Act (UTMA)
- Uniform Gift to Minors Act (UGMA)
Each account can hold all types of financial assets like cash, stocks, bonds, mutual funds, annuities, and insurance policies. An UTMA can hold other assets like art and property.
These accounts offer maximum flexibility – the funds can be used for virtually anything that will benefit a minor including clothes, food, housing, etc., and there are no contribution limits or withdrawal penalties.
The IRS views the child as the account owner, therefore all gains and earnings are taxed at the child tax rate. Any child under 19 (or 24 if a full-time student), can have up to $1,100 of unearned tax-free income. Surpass $2,200, and the earnings are taxed at the parent’s tax rate.
Custodial accounts aren’t tax-sheltered, which can cause undue tax burdens when the child turns 18. Custodial accounts also count on the student’s FAFSA, which could make federal or community aid harder to come by.
Since the assets technically belong to the child, they are free to spend the money on whatever they wish, college or otherwise, when they turn 18. This places a lot of financial responsibility on a young adult.
These accounts are much simpler and affordable to establish than a traditional trust and can be an efficient method for helping your kids pay for school. Given your student would have full control of the money once they come of age, they must be prepared for that undertaking.
Outside of more structured education accounts, you can also invest in qualified U.S. Savings bonds, a brokerage account, and more. Be sure to work with your financial planning professional to build a savings plan that works for your family now and in the future.
Three Tips to Make Your College Payment Plan Smarter
Now that you’re geared up to save for college, what are other avenues you can leverage to help pay for it?
Dive Deep Into Grants, Scholarships, Aid, and Other “Free” Money
Remember the sticker price for college talk at the beginning? Normally, the sticker price isn’t what most families end up paying given grants, scholarships, and other financial aid opportunities.
Families must leverage all of their financial aid options to help decrease the total cost of school. That might mean digging around for local, institutional, and national scholarships, having your kids write essays or make presentations, among other options.
Don’t Be Afraid to Appeal Your Financial Aid
Financial aid appeals can be a relevant part of your student’s application process. In most cases, schools grant aid packages based on a formula that estimates how much money the school thinks you can pay. This factor is called your Expected Family Contribution (EFC) and is based on the information provided in FAFSA.
Since FAFSA uses tax data from two years before the application, several circumstances could have changed your EFC like job loss, injury or illness, and more. You can also appeal for more aid if your child achieves higher standardized test scores and/or GPA than when they first applied.
The appeals process is different at each institution. Generally, you find your point of contact, then write a short, detailed, and persuasive letter indicating why you’re appealing the package. It’s best to include documentation to substantiate your claims like test scores, termination notices, tax statements, etc. In general, it is easier to appeal aid decisions at private colleges and universities.
Consider and Create a Student Loan Plan In Advance
Even with all your diligent savings and aid opportunities, it still might not be enough to cover the entire college bill. That’s where loans come in.
Knowing approximately how much your child may need to borrow up front gives you (and them) more time to make strategic choices about how much debt to incur. You can also create a preliminary repayment plan so they are aware of the financial burden they are assuming.
Build a Roadmap
The first step in paying for college is to build a financial roadmap. On your journey to paying for school, walk through the following questions:
- How much can you expect to save given your contributions and investment vehicles?
- Which schools are on the table and what value will they bring your child long-term?
- Are you still putting enough money aside for retirement?
- Will you or your child need to take out loans to help pay for school?
- Have you exhausted your options for additional funds like merit- and need-based aid or other targeted financial aid appeals?
College planning has many variables; perhaps the most challenging for parents is not sacrificing future retirement savings for their children’s present education costs.
In nearly all cases, it makes sense to prioritize your retirement. That doesn’t mean you have to stop funding your child’s 529 accounts, it just means you shouldn’t necessarily decrease your annual 401(k) contribution to increase funds for school.
Creating a financial plan early on will help you map out this crucial balancing act.
At Abacus, we’re passionate about helping you expand what’s possible with your money. Education is one of the greatest gifts you can give, and if funding college is part of your financial goals, we can help you create a plan to get there. Set up a call with us to talk about your education planning journey today.
One last thing: This overview just skims the surface of saving and preparing for college. We talked with renowned author Ron Leiber about his book, The Price You Pay for College: An Entirely New Road Map for the Biggest Financial Decision Your Family Will Ever Make, as well as his thoughts on the college planning process. If you want a deeper dive into this subject, check out our free webinar.
