Education Planning 101: How Parents Can Save for College

Education planning is a crucial step for every family. With the cost of education on a continuous upward trend, it's more important than ever to create a well-thought-out plan that will cover future expenses while taking advantage of various financial tools. Education planning can provide a sense of preparedness by offering a strategy to address these costs. This guide explores a variety of financial vehicles and strategies to help fund your child's education.

The Importance of Education Planning

Education is one of the most significant investments you can make for your child, but it is also one of the most expensive. In the United States, the average cost of tuition, fees, and room and board at a public, four-year university was over $27,000 per year as of 2024, while private institutions can easily surpass $50,000 annually. Without a solid plan, these costs can become overwhelming.

Starting early allows you to not only prepare for these expenses but also benefit from the growth potential of investments over time. Education planning encompasses more than just setting aside money; it involves selecting savings vehicles that help optimize tax benefits and work toward reaching the financial goals needed for education by the time your child reaches college.

Key Financial Vehicles

529 Plans

A 529 Plan is often the go-to choice for parents looking to save for their child’s education. It’s a state-sponsored, tax-advantaged savings account that offers significant benefits to those who use it for educational purposes.

• Overview: 529 Plans come in two varieties: education savings plans and prepaid tuition plans. Education savings plans work much like a retirement account, where investments grow tax-free, and withdrawals for qualified education expenses are not taxed. Prepaid tuition plans allow you to lock in today's tuition rates for future college expenses, although they are more limited in scope.
• Benefits: Not only do your contributions grow tax-free, but many states offer tax deductions for contributions. You can use the funds to pay for a wide range of education-related expenses, including tuition, books, supplies, and even room and board.
• Drawbacks: The main limitation of a 529 Plan is that it must be used for qualified educational expenses; otherwise, you face penalties on withdrawals.

Coverdell Education Savings Accounts (ESAs)

While 529 Plans are widely known, Coverdell ESAs provide additional flexibility, particularly if you’re planning to cover K-12 education expenses as well as college.

• Overview: A Coverdell ESA allows for tax-free growth, similar to a 529 Plan, but with more flexibility in how the funds are used. Unlike 529 Plans, which are limited to higher education, Coverdell accounts can be used to pay for K-12 expenses as well, including private schooling and tutoring.
• Benefits: The Coverdell ESA offers the advantage of a broader range of investment options compared to 529 Plans. You can use it for a wide variety of educational expenses, including tuition, books, supplies, and even extracurricular activities like tutoring or specialized education programs.
• Drawbacks: The primary downside of a Coverdell ESA is the annual contribution limit of $2,000 per beneficiary, which is significantly lower than the contribution limits for 529 Plans.

Custodial Accounts (UGMA/UTMA)

Custodial accounts offer an alternative for families who may want more flexibility in how the funds are used, even beyond education.

• Overview: Custodial accounts under the Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) allow adults to gift money to minors, which can be used for any purpose, including education.
• Benefits: One key benefit of UGMA/UTMA accounts is the ability to use the funds for a broader range of expenses, not just education. Additionally, the account becomes the child’s asset when they reach the age of majority, giving them full control over the funds.
• Drawbacks: The fact that the account transfers ownership to the child at a specific age could impact their eligibility for financial aid, as the funds are considered the child’s asset.

Roth IRAs

Though primarily designed for retirement, Roth IRAs can serve a dual purpose by helping to fund education expenses.

• Overview: Roth IRAs allow for tax-free growth and tax-free withdrawals for qualified education expenses, making them a versatile financial vehicle.
• Benefits: The most significant benefit of using a Roth IRA for education planning is its flexibility. You can use the contributions you’ve made without penalty at any time, and while earnings are typically reserved for retirement, you can withdraw them penalty-free for qualified education expenses.
• Drawbacks: While Roth IRAs offer flexibility, the contribution limits are relatively low ($7,000 per year as of 2024), making it less useful as a sole savings vehicle for education. Additionally, withdrawals for education can reduce the amount available for retirement.

Strategic Considerations

Start Early

The earlier you start saving for education, the more time you allow your money to grow. The power of compound interest means that even small, regular contributions made early on can grow substantially over time. For example, if you begin saving $200 a month when your child is born, by the time they are 18, you could have over $70,000 saved, assuming an average annual return of 6%.

Diversification

No single financial vehicle will perfectly meet all your needs. A diversified approach allows you to balance the benefits of tax-advantaged accounts like 529 Plans and Coverdell ESAs with the flexibility of UGMA/UTMA accounts and Roth IRAs. For example, you might use a 529 Plan for tuition and a Roth IRA for additional expenses like housing, or a custodial account for general child-related expenses.

Regular Contributions

Consistency is key when it comes to education savings. Automating your contributions can help ensure you stay on track with your savings goals without the temptation to delay or skip contributions. You can set up automatic transfers from your paycheck or checking account to your 529 Plan, Coverdell ESA, or any other savings account. Over time, these regular contributions will accumulate into a significant education fund.

Balancing Financial Aid and Tax Benefits

Understanding how your savings can impact financial aid eligibility is a crucial part of education planning. While 529 Plans and Coverdell ESAs are viewed as parental assets, custodial accounts are considered the child’s assets, which can significantly reduce the amount of need-based financial aid your child may qualify for. The strategic use of savings vehicles can help balance financial aid eligibility with the benefits of tax-free growth.

• 529 Plans and Financial Aid: The assets in a 529 Plan are considered parental assets, which are assessed at a lower rate when calculating Expected Family Contribution (EFC) for financial aid purposes. However, withdrawals from a 529 Plan are not counted as income on financial aid applications, which can be a significant advantage.
• Custodial Accounts and Financial Aid: Unlike 529 Plans, assets in UGMA/UTMA custodial accounts are considered the child's property, which can significantly impact financial aid eligibility. Because financial aid formulas assess student-owned assets at a higher rate than parental assets, custodial accounts may reduce the amount of need-based aid. However, they offer greater flexibility for non-educational expenses, allowing families to address broader financial needs beyond education costs. This trade-off between flexibility and financial aid implications should be considered when incorporating custodial accounts into your overall savings strategy.

How to Monitor and Adjust Your Plan

Education planning isn’t a one-time task. As your child grows and their educational needs evolve, you’ll need to revisit and adjust your plan accordingly. It’s important to review your savings progress annually to ensure you're on track to meet your goals. You may need to increase contributions or adjust your investment strategy based on market conditions, tax law changes, or shifts in your financial situation.

Additionally, keep an eye on changes in the cost of education, especially if your child is considering private schooling or out-of-state tuition. These costs can vary greatly depending on the institution and geographic location.

Conclusion

Education planning is a dynamic process. By starting early, diversifying your financial tools, and regularly contributing, you can build a solid foundation for your child's education. Don’t forget to review your plan periodically and adjust as necessary to accommodate changes in costs and personal circumstances. With a well-executed strategy, you’ll be able to provide for your child’s education without unnecessary financial strain.

Article published on 9/11/24

Disclaimer

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The information in this article has been sourced from educationdata.org, collegeboard.org, and irs.gov.

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

Prior to investing in a 529 Plan, investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.​

Beginning January 2024, the Secure 2.0 Act of 2022 (the "Act") provides that you may transfer assets from your 529 account to a Roth IRA established for the Designated Beneficiary of a 529 account under the following conditions: (i) the 529 account must be maintained for the Designated Beneficiary for at least 15 years, (ii) the transfer amount must come from contributions made to the 529 account at least five years prior to the 529-to-Roth IRA transfer date, (iii) the Roth IRA must be established in the name of the Designated Beneficiary of the 529 account, (iv) the amount transferred to a Roth IRA is limited to the annual Roth IRA contribution limit, and (v) the aggregate amount transferred from a 529 account to a Roth IRA may not exceed $35,000 per individual. It is your responsibility to maintain adequate records and documentation on your accounts to ensure you comply with the 529-to-Roth IRA transfer requirements set forth in the Internal Revenue Code. The Internal Revenue Service (“IRS”) has not issued guidance on the 529-to-Roth IRA transfer provision in the Act but is anticipated to do so in the future. Based on forthcoming guidance, it may be necessary to change or modify some 529-to-Roth IRA transfer requirements. Please consult a financial or tax professional regarding your specific circumstances before making any investment decision.

Investing involves risk, including risk of loss.

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