Every parent wants what’s best for their kids. And a big part of that? Education. And as every parent knows, saving for that education is a task unto itself.
Let’s all commiserate for a second: For kids born in 2018, the cost of a four-year degree at a public in-state college is expected to be more than $43,000 a year. For a private, for-profit school, that number is expected to be more than $93,000 a year. (And then they keep asking for more once we’re alumni … I’m with you, John Mulaney.)
So if you’re in a position to do it, saving for your children’s educations can be great for their future. That’s why, as a financial advisor, I get a lot of questions about how to do that. There are good choices no matter what your income is — here’s a breakdown of the most common ones, plus some pros and cons for each.
1. 529 college savings plan
This one’s first on the list for a reason: 529 education savings plans (commonly called 529 college savings plans) have great tax benefits, and they’re a good option whether you’re able to contribute a lot or a little. That’s because there’s no income or annual contribution limit.
A 529 college savings plan is a tax-advantaged investment account that can be used to save for education-related expenses for a designated beneficiary (aka that kid you love so much). Often, when you use a 529, you can choose an age-based investment option that will adjust the investment risk as your child gets older.
The money you put in a 529 grows tax-free, and withdrawals are also tax-free if they’re used for qualified education expenses. This includes the cost of college itself — including required things like tuition, room and board, books, and computers — and, in many states, up to $10,000 a year for K–12 tuition. Plus, depending on where you live, you might get state tax benefits on contributions, too. (Niiiice.)
Most 529 plans are run by the states, but fun fact: You actually aren’t required to use the plan from the state where you live. (Some states won’t give you those state tax benefits unless you use theirs, though.)
Another benefit of using a 529 plan is that it generally doesn’t have a very big effect on what your child will be eligible for when it comes to financial aid. (Everybody wants to max out that financial aid, amiright?) That’s because parents’ savings have a smaller impact than parents’ or students’ income. If well-meaning grandparents, aunts, uncles, etc. start a 529 for your child in their own name, though, withdrawals will count as income for the student and affect financial aid.
Once you put money into a 529, there’s no date you have to use the money by. There’s also no IRS-imposed annual contribution limit, although most states have a total account size limit. Also, if you’re able to make sizeable contributions, keep in mind that deposits into 529s count as gifts, so you may want to keep annual contributions under the annual gift tax limit. (Although you can contribute more at once if you treat it as a gift over five years. That’s a good thing to discuss with a financial advisor.)
Now for the potential downside: The money you save in a 529 plan is meant to be used for education expenses. If you withdraw for a non-qualified reason, you’ll owe all those taxes that you didn’t have to pay before. Plus a 10% penalty on top of that. Ouch.
And so what if your child decides not to go to college? (Best laid plans. 🤷) In that case, you can change the beneficiary to a different member of the family — perhaps to a different child, a niece or nephew, a grandchild, or even yourself.
On the other end of the spectrum, if your kid gets a scholarship (WOOO!), you can usually withdraw the amount of their award without that 10% penalty (although you’d still owe taxes). You could also save it for grad school, if they plan to go, or change the beneficiary to someone else.
The investment choices in a 529 can also be pretty limited. This is why you might want to shop around between different state plans for other, less expensive options (keeping in mind that you might miss out on state tax benefits if you do).
2. 529 prepaid tuition plan
A 529 prepaid tuition plan lets you … wait for it … pre-pay for blocks of tuition at a specific school today. That means you’re locking in today’s prices at that school. This usually includes tuition and fees only — not room and board, books, etc. (Womp.)
These are available in a handful of US states, and your child would have to attend a public school in that state (unless you’re using Massachusetts’ plan, which lets you go out of state). You often have to actually live in that state, too.
For private schools, there’s also an independent plan called the Private College 529. It works much the same way but allows your kid to choose among almost 300 private schools around the US instead.
So this might be an option for you if you think that the cost of tuition is going to continue to soar (probably a good bet), and if you’re pretty sure you can predict where your child will want to go to school (hate to break it to you, but even if multiple generations of your family went to Michigan — go Blue! — this is probably less of a good bet).
Also useful to know: 529s prepaid tuition plans all have different terms, including limits on how the money can be used, when the beneficiary has to start college, if there’s an age limit for the beneficiary, whether there are refunds or other options if the beneficiary doesn’t go to school there, and if your savings are guaranteed by the state (or someone else, or at all).
3. Coverdell Education Savings Account
Coverdell Education Savings Accounts (ESAs) are pretty similar to 529s. The big difference used to be that you could use them for K–12 expenses, but now you can use a 529 for K–12 tuition, too … so.
But there are a few other differences as well. For example, you have more flexibility with what you can withdraw money for during elementary and high school — things like those uniforms that are impossible to keep clean, and tutoring so they can smash the SAT (you know they will) are usually fair game here. Also, you often have more, and maybe cheaper, investment options with a Coverdell ESA.
Differences that aren’t so fun: There’s a $2,000 annual contribution limit per child, and they have to be under 18 when you put money in. Then they have to use the money by their 30th birthday (unless they’re a special needs dependent). If they don’t end up needing the money, you can change the beneficiary to a different relative who’s under 30.
Also, there are income limits. If you make more than $110,000 ($220,000 if you’re married filing jointly), you aren’t eligible to use a Coverdell ESA. If you make between $95,000 and $110,000 ($190,000 and $220,000 if you’re married filing jointly), the amount you can contribute will be reduced.
4. Roth IRA
Quick aside here: Saving for college does not have to be your top priority. For many of my clients who are parents, this can be hard to come to terms with — they’re hard-wired to put their kids first (thanks, Mom!). But student loans, scholarships, and grants exist. There’s no such thing as a retirement scholarship.
Which brings me to Roth IRAs. At their core, these are retirement accounts. But you can withdraw your contributions penalty- and tax-free from a Roth IRA at any time, and they let you withdraw your earnings early without penalty for a handful of reasons — including education expenses for you, your spouse, or your kids or grandkids (but you’ll still owe taxes).
So the cool thing about going this route is that it gives you options: You can use the money in a Roth IRA for your retirement if you need it, or you can use it for qualified education expenses (the same ones you can use 529s for) if that works for your long-term goals.
Keep in mind that Roth IRAs come with an annual contribution limit of $6,000 ($7,000 if you’re over 50). There are also income limits to be eligible to use a Roth IRA.
Because it counts as retirement savings, having money in a Roth IRA won’t have a big impact on your child’s eligibility for financial aid. But withdrawing the earnings boosts your income … which probably would. So if you want to use a Roth IRA for education, one option might be to hang on to the money until your child graduates and then use it to pay off any loans after.
5. Taxable investment account
If you want to invest for future education costs but you’d rather be free to spend it on whatever your kid needs, a regular taxable investment account might work for you.
You won’t get any special tax benefits, but you’ll have the most flexibility — both in how you spend the money and in the investments you can choose (meaning you have more of a say in controlling your fees). Also, there wouldn’t be any penalty if you wanted to use the money for something other than education, if life should happen that way.
If you go this route, it’s often a good idea to adjust the risk in the investment portfolio to get more conservative as you get closer to the date when you’ll need the money (or choose an investment platform (or advisor) who can do that for you).
Just FYI, if your account has capital gains and you use those assets to make withdrawals, that could affect your income, which could affect financial aid.
6. UGMA or UTMA account
If your income is too high for a Coverdell ESA or Roth IRA but you’re looking for more flexibility or higher contribution limits, then a custodial Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account might work for your kid instead.
You typically open one at a bank or trust company. You’ll choose a custodian (probably you) and name a beneficiary (your child). When your child reaches the “age of majority” in your state — often 18 or 21 — the assets will transfer to them, and they can spend the money however they want (good if you think they’ll buy books — less good if you think they’ll buy … not books).
The difference here is that this account belongs to your child, not to you. Their withdrawals will be subject to the “kiddie tax” rates, which gives them a little bit of a break. But that also means that as far as financial aid goes, this will count against them, because your kid’s assets factor heavily into those decisions.
7. 2503(c) trust
Also called a minor’s trust, a 2503(c) trust works a lot like a UGMA/UTMA account when you use it for education expenses. The downsides are that they’re harder to set up (an attorney is a must), the taxes might be higher and more complicated, and these assets would factor heavily into financial aid decisions. But the upsides are that you might be able to write the terms so that your child doesn’t automatically get control of the money once they turn 18 or 21 (you just have to give them a temporary window of opportunity to withdraw if they want). Also, the money is usually protected from your child’s creditors.
Unless the tuition bill is due now, it’s never “too late” to start investing for education. Every little bit can help, and every day your money is invested is another opportunity for it to grow and make an impact on their future financial security.
Ellevest can help all clients with Roth IRAs and taxable investment accounts. The Ellevest Private Wealth Management team can also help their clients with Coverdell ESAs and UGMA/UTMA accounts; 2503(c) trusts can be opened but are subject to review and approval of the trust documents. At this time, Ellevest is unable to help clients with 529 college savings plans.