When it comes to financial goals, saving for retirement may take top billing. But if you also have children, saving for their education could become another top priority.
How do you balance these two somewhat competing goals?
With college costs rising at approximately twice the inflation rate over the last twenty years, parents must figure out the best ways to save for their children. Unfortunately, there is no one-size-fits-all answer, but we share four ideas worth considering in this article.
- Open A 529 Plan
- Carefully Consider A Custodial Account
- Look Into A Coverdell ESA
- Use A Roth IRA
Open A 529 Plan
The 529 plan is the most tax-efficient and well-known college savings vehicle and has many excellent characteristics. Some of the more critical details of 529 plans are as follows:
- You make contributions with after-tax dollars.
- These accounts allow for tax-free growth as long as expenses are considered qualified education expenses. Non-qualified expenses incur a 10% penalty.
- Most plans have generous lifetime contribution limits.
- Anyone can open a 529 Plan in any state (even if you don’t live there), but some state’s 529 plans allow for tax credits or deductions. Therefore, if you live in one of those states, it may be beneficial for you to open a 529 Plan in your state of residence.
- You can use up to $10,000 for K-12 Education and $10,000 for student loan repayment (SECURE Act).
- These plans allow for changing beneficiaries, which provides flexibility if one child gets a scholarship or does not go to college.
For a deeper dive and more details into 529 plans, check out our article on using your 529 plan to your advantage.
Consider A Custodial Account
There are two types of Custodial Accounts you may come across:
- UTMA (Uniform Transfers to Minor Act), and
- UGMA (Uniform Gift to Minors Act).
These accounts allow you to invest funds on behalf of your child. Until the age of majority in your state (18 or 21), you can use the funds for anything required to support your child, like food, clothing, etc. As the “custodian,” you can contribute stocks, bonds, real estate, and even assets like art or collectibles into this account.
An important caveat is once your child turns 18 (or 21), the money belongs to them. They can use the funds as they see fit, for college or otherwise. This situation could be tricky if your wishes do not align with your child’s desires once they become the majority age.
Custodial accounts are very flexible because you can cover college costs which aren’t typically defined as “qualified education expenses,” such as flights, other transportation, medical expenses, and health insurance. In addition, if your child does not take the traditional college path, they could use the UTMA (or UGMA) for costs associated with a vocational job or an entrepreneurial path.
Look Into A Coverdell ESA
The Coverdell ESA (Education Savings Account) operates similarly to a 529 plan but with stricter contribution and income limits.
For 2021, the Coverdell ESA’s annual contribution limit for each child is $2,000 per beneficiary, and the income limit for making a maximum contribution is as follows:
- $190,000 for those filing a joint return (phased out at $220,000)
- $110,000 for those NOT filing a joint return
Use A Roth IRA
While most people only use their Roth IRA to help fund their retirement, you can also use those funds to help cover your children’s college bills. Doing so may not make sense for everyone, but it can be helpful because of the flexibility inherent in your Roth IRA.
The IRS allows you to take penalty-free withdrawals from your Roth IRA to pay for college education expenses. Assuming you follow Roth IRA withdrawal and holding period rules, your first “layer” of withdrawals will be considered “contributions.” Only these withdrawals will be tax-free.
It is vital to consider Roth IRA withdrawals concerning their impact on FAFSA (Free Application for Federal Student Aid). All distributions count as income on the following year’s FAFSA, limiting eligibility for federal aid.
Finally, by using your Roth IRA to fund your children’s education, you remove tax-free funds for your retirement goals—yet another reason why building a financial plan fit to support all of your goals is so essential.
Create A Realistic And Consistent Savings Plan
When it comes to funding college savings goals, there are certainly many different ways to save. If you are starting, prioritize building a plan that works for your budget.
When it comes to competing goals or priorities, it’s critical to assess your specific goals with regard to funding your child’s education.
- Are you willing to work longer to fully fund your child’s education?
- Do you want your student to have “skin in the game”?
- Or do you want to retire earlier, providing for only a portion of your child’s education expenses?
Once you have defined your goals towards your child’s college funding, creating a reasonable systematic investment plan based on your goals is the next step.
Of course, there are many other complementary ways to assist in funding college such as scholarships, grants, work-study, federal and private student loans, and paid internships to name a few.
With the college landscape rapidly changing due to the pandemic, it’s more important than ever to build a funding plan with the flexibility to meet your family’s goals and values.