Within the last 30 years, college tuition and fees have tripled at public universities! The average tuition and fees for the 2020-2021 school year reached nearly $36,000, not including housing, food, and supplies.
With those numbers in mind, it’s no surprise that you need to have a college savings plan in place sooner rather than later.
Not sure where to start? Let’s go over the top 5 ways that you can begin saving for your kid’s college experience.
#1. 529 Plans
One of the most common ways to save for your kid’s college is through a 529 plan.
A 529 plan is a state-sponsored savings account that you can use to pay for education costs. They work similarly to a Roth 401k or Roth IRA in that you invest after-tax contributions, so when you withdraw the money, it won't be taxed. Keep in mind that for tax-free withdrawals, you must use the funds for qualified education expenses, like tuition, room and board, books, supplies, etc.
This type of savings vehicle is also tax-friendly because many states will allow you to deduct contributions from your state income tax. If you’re a Mississippi resident, you can deduct up to $20,000 in contributions per year if married filing jointly, and $10,000 if filing single on your state income tax return.
Unfortunately, North Carolina does not offer in-state tax deductions for contributions to the state’s 529 accounts. But we have good news: you can contribute to any state's 529 plan! For example, you can live in North Carolina but contribute to Ohio’s state plan without a problem.
People love 529 plans for their flexibility. With tax-deferred growth, tax-free withdrawals, and high accessibility, they are an extremely popular savings account across the U.S. Note that while these savings vehicles have very high annual contribution limits, many people like to keep contributions within the gift tax limit of $16,000 for 2022. That way, you don’t have to claim the excess as a gift tax.
The bottom line? If you have children that you hope to send to college and are looking for a viable option, you should consider opening an account sooner rather than later. The earlier you invest, the more opportunity the funds have to grow and compound, helping you reach your savings goal.
There are two types of 529 plans to consider
College savings plans and prepaid tuition plans are the two main 529 plans. They may sound similar, but they have distinct differences.
The most popular option is the college savings plan (the one we discussed earlier), which allows you to contribute after-tax dollars into an investment account, the funds grow tax-free, and withdrawals for qualified education expenses remain tax-free.
You can use 529 funds to support a broad range of education costs—from pre-school to graduate (even limited student loan repayment). It’s also possible to change beneficiaries to support other family members should there be leftover funds. These more comprehensive applications make college savings plans the more popular of the two.
A prepaid tuition plan allows you to ‘lock in’ tuition at the current rate to pay for all or a portion of tuition and fees in advance. There are more restrictions with this type of plan, including:
- You can’t use the funds for elementary or secondary education.
- Distributions can only help fund tuition and mandatory fees. Housing and books are not included.
- The federal government does not guarantee these plans (and may not be guaranteed by some states).
- Not all universities accept prepaid tuition plans.
#2. Education Savings Accounts
Also known as Coverdell Savings Accounts, an Education Savings Account (ESA) is a tax-deferred trust account. Earnings accumulate tax-free, and distributions are income tax-free, as long as you use them for educational purposes.
These accounts work similar to 529 plans, but Coverdell ESAs allow for more flexibility regarding how you can use the funds. Funds aren’t limited to tuition; expenses can also include books, supplies, or even tutoring.
Coverdell ESAs have three important stipulations professional athletes should know:
- The maximum contribution per child per year is $2,000.
- Coverdell ESAs are only available to families with less than $190,000 in modified adjusted gross income. (This generally eliminates most professional athletes but I think that it is important to be aware of the possibilities.)
- Funds must be used by the time a student reaches 30, or you’ll face taxes, fees, and withdrawal penalties.
On the plus side, it’s possible to contribute to a 529 plan and an ESA if it fits into your financial plan.
#3. A Roth IRA
You may be surprised to discover that Roth IRAs don't have to be just for retirement!
A Roth IRA can be an excellent way to help your child pay for school. Although you can use your personal account, you could also open a custodial Roth IRA for your child. This enables them to save early and allocate some funds for higher education.
There are some costs and taxes to keep in mind.
With Roth IRAs, you contribute after-tax dollars. Since you already paid tax on the contributions, you can have access to those at any time. It’s the earnings/growth that get tricky.
If you wait until retirement, gains and qualified withdrawals are tax-free. If you withdraw early, you’d typically face a 10% penalty.
But, the IRS makes an exception for college expenses.
You can withdraw earnings from your Roth IRA early for qualified education expenses, but you must pay income tax on the distribution if withdrawn prior to age 59 1/2.
Note that there are contribution and income limits with this savings vehicle:
- No matter how you use Roth IRAs (retirement, college, etc.), the 2022 contribution limit of $6,000 still applies, which is significantly lower than what you could put into a 529 plan.
- Roth IRAs have income limits for direct contributions of $144,000 if you’re filing single and $214,000 if you’re married filing jointly (this generally eliminates most professional athletes, but it's important to be aware of the possibilities).
- Income from a Roth IRA counts on the FAFSA, which could jeopardize your child’s eligibility for need-based aid.
You may decide to use a Roth and a 529 plan as a dynamic duo to save for your kid’s college. Check with your financial advisor to ensure you qualify to contribute to both savings vehicles.
#4. Custodial Accounts
Another effective way to save for college is through a custodial account, which is a taxable trust that an adult controls for a minor.
There are two forms of custodial accounts—the Uniform Gift to Minor Act (UGMA) and the Uniform Transfers to Minors Act (UTMA). The main difference between the two is that a UGMA is limited to financial assets such as cash, stocks, mutual funds, and bonds. UTMA accounts, on the other hand, can hold any asset such as real estate or collectibles.
Custodial accounts have a lot of advantages, one being that there is no limit to how much money you can contribute. Like 529 contributions, most people adhere to the gift tax guardrails, which limits your investment to $16,000 per year. Custodial accounts also allow withdrawals at any time if they go directly to the beneficiary.
The twist is that money doesn’t only have to go toward education expenses. This caveat could be a significant advantage if something unexpected and costly happened. For example, say your child got into a car accident and totaled their car. In that case, you could use those funds to purchase a new vehicle.
On the other hand, since the funds belong to the child, once they turn 18 or 21, depending upon state law, they can spend the funds however they want. It could be anything from a motorcycle to a lavish spring break vacation, so make sure this is a good option for you and your child in terms of financial responsibility.
#5. Whole Life Insurance
Life insurance? College expenses?
Believe it or not, the two could go together if all the stars align.
Unlike term life insurance which pays out a death benefit when the beneficiary passes, whole life insurance offers a death benefit and a tax-deferred savings account, known as the cash value component.
Whole life insurance gives more flexibility than 529 plans, and similar to custodial accounts, you’re not limited to using the funds for educational expenses and can access them at any time for any reason.
There are many ways to use your savings to pay for college tuition, including:
- Borrowing against the cash value
- Withdrawing a portion of the cash value
- Surrendering the policy to receive the entire cash value (though you will need to pay a surrender fee)
There are some important downsides to using life insurance for college expenses:
- It can be quite expensive. Fees can chip away at the account earnings, and it can take time for the account's value to surpass the premium costs paid, depending upon the structure of the policy.
- You need to plan ahead. As with all saving and investing strategies, it takes time to accumulate funds. Whole life insurance can be expensive and based upon the structure of the policy, it can take many years to accumulate the cash value you need.
Bonus Tip: Promote Financial Literacy
It’s not enough just to save for your children’s college; they need to know what to do with that money—and understand the value it holds—once they enter college. Financial literacy is the key to securing a strong financial future for your children.
There’s no time like the present! Take control of your college savings strategy and get in touch with one of our professionals at Pro Wealth.
This information does not constitute an offer to sell or a solicitation of an offer to buy any securities or investment strategy and is intended for informational purposes only. Investments are subject to market risk, including the loss of principal, and the investment strategies described may not be suitable for all investors. Equities are subject to market risk meaning that stock prices, in general, may decline over short or extended periods. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting, tax advice, or a representation that any investment or strategy is suitable or appropriate.