August 6, 2018
August 6, 2018
Are you looking for ways to save for college? With the average cost of a college education now at over $100,000 for four years at a public college, and over $200,000 at a private college, parents need all the help they can get to save for college.
Fortunately, there are several well-established ways to make that happen. You can choose which plans you will use, or take advantage of a combination of two or more.
529 plans have been set up specifically to fund a child’s college education. They work something like a Roth IRA – though your contributions to the plan are not tax-deductible, investment income can accumulate on those contributions tax-free.
They must be invested in investment plans offered by the various states, and the majority of states do provide them. You can invest in a plan in the state where your child expects to attend college.
There are no limits on how much money you can contribute to a 529 plan. However, most people contribute no more than the federal annual gift limit of $15,000, to avoid incurring a potential gift tax. Parents can contribute to the plan, but so can grandparents. Also, you can continue making contributions to the plan even while your child is in college.
The money can be withdrawn tax-free as long as it is used to pay for qualified education expenses. These include tuition, books, fees, room and board, and even a computer and other equipment if they are required by the plan of study.
These are similar to 529 plans but more limited in scope. Contributions are not tax-deductible, but investment earnings may accumulate on a tax-deferred basis. Distributions must be made to cover qualifying education expenses.
Contributions to a Coverdell ESA are limited to just $2,000 per beneficiary, and you cannot make contributions once the child reaches the age of 18.
There are also income limits to participate in a Coverdell ESA. Individuals must earn no more than $110,000 per year, and couples filing jointly cannot exceed $220,000 per year.
The major advantage of a Coverdell ESA is that there is no limit on how or where you may invest the money. And unlike a 529 plan, you’re not required to invest in a state-sponsored investment plan.
Roth IRA plans are retirement plans, and not specifically set up for funding a college education. But because of the way Roth IRA plans are structured, they’re an excellent source of college funding.
You can contribute up to $5,500 per year to a Roth IRA ($6,500 if you are 50 or older). Plans are fully self-directed, which means you can choose the investment trustee as well as the specific investments you will hold in the plan.
Contributions to a Roth IRA are not tax-deductible, but investment earnings on those contributions are tax-deferred. Once you reach age 59 ½ and have participated in a Roth IRA for a minimum of five years, distributions from the plan can be taken completely tax-free.
But the part that works for college savings is what’s known as the Roth IRA ordering rules. If you make early withdrawals from a Roth IRA, the first funds that are withdrawn are your contributions. And since those were not tax-deductible, you are not required to pay ordinary income tax or the 10% early withdrawal penalty on the amount taken.
For example, let’s say that you have a Roth IRA with $65,000 in it. $40,000 are your contributions, and $25,000 are investment earnings. If you decide to withdraw $30,000 to pay for your child’s college education, there will be no tax liability on the withdrawal. The $30,000 taken is less than your $40,000 in contributions.
These are accounts you set up for your child. There are two varieties – the Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA). You can hold these accounts in any form you wish, a bank account, investment brokerage, or mutual funds.
Like the 529 plan, there’s no limit to how much you can put into the account. But again, most donors limit contributions to no more than $15,000 per year, to avoid incurring the gift tax.
Contributions are not tax-deductible, and while investment earnings are not tax-free, there is something of a tax break on those earnings. The first $1,000 in income earned in the account is tax-free. The second $1,000 is taxed at the child’s tax rate (which is very likely zero). Anything above $2,000 is taxed at the parent’s rate.
One of the big advantages of the custodial account is that there is no restriction on the use of the funds upon withdrawal, nor are there any tax consequences. The funds can be used for education, but also for other purposes, such as opening a business.
The account will become the property of the child once they reach the age of majority, which is either 18 or 21 depending on which state you live in.
If you’ve been unable to save money for your children’s college education, but you’re a homeowner with a lot of home equity, this is another option.
Rather than taking student loans, you can do a cash-out refinance on your home, and use the cash proceeds to pay for your child’s education.
There are no tax consequences to a cash-out refinance. But the new mortgage will generally provide a lower interest rate than a typical student loan. And since it will be financed over 30 years, the payment impact will be minimal.
Also, you won’t be burdening your child with a student loan repayment after graduation. And since your house is an appreciating asset, your home equity is very likely to increase after you do the cash-out refinance.
Any of these savings methods is a way to accumulate a significant amount of money for your children’s college educations. Even better, you should consider using a combination of several. And with the cost of a college education today, that strategy will make a lot of sense.