Get Schooled on College Savings Plans
Partner and Financial Advisor, Armstrong Advisory Group
A lot of parents start obsessing over the thought of saving for college when their kids are very young. I have three daughters who are all under the age of three and this issue, along with our sleepless, heavy-diapered newborn baby, already keeps me up at night. Because of the sheer number of college savings plans out there these days, it’s easy to get confused and overwhelmed as you strive to make the best financial decisions on behalf of your kids. The numbers back me up on this. According to Fidelity’s annual College Savings Indicator Study, 50% of parents in the U.S. can’t decide which college savings plan to choose. If you’re one of those parents, this blog post is for you. Let’s have a look at some of your options. I’m sure you’ll quickly realize that this really isn’t rocket science.
529 plans are one of the most well-known college savings plans around, so chances are that you’ve probably heard of them. There are two types of 529 plans: prepaid tuition plans, which allow you to buy credits or units at a participating college or university on behalf of your future scholar, and education savings plans, which allow you to open an investment account and save for college on a tax-free basis. All 50 states (plus the District of Columbia) offer at least one type of 529 plan and some states go the extra mile by offering a tax break for your contributions to a 529 plan. In addition, there are generally no income limitations and most 529 plans have high contribution limits.
Remember that the purpose of a 529 plan is to save money for tuition and higher education expenses only. (Sorry, but your kid can’t use the money to buy a car.) If your child doesn’t go to college, you could always change the beneficiary of the plan. However, if you do not spend the money on education-related expenses such as tuition, room and board, textbooks, and other various fees, you’ll have to fork over federal income taxes and a 10% penalty on the account’s earnings. If your child gets a full scholarship to college and no longer needs their 529 plan, you can usually get the 10% penalty waived. In addition, the Tax Cuts and Jobs Act allows parents to use some 529 funds to pay for K-12 tuition expenses. Click here to view each state’s 529 plan options.
Coverdell Education Savings Accounts (ESAs)
Although Coverdell ESAs are another example of a tax-free education savings plan, they’re different from 529 plans in several ways. For starters, you can use Coverdell ESAs to pay for tuition and other qualified education expenses on behalf of your child at any grade level. It doesn’t matter if they’re in elementary school, college, or going to a private high school because they need a little extra help. However, contributions to a Coverdell ESA can’t exceed $2,000 in any year. In addition, you’d have to make Coverdell ESA contributions in cash and, sadly, you won’t get any tax breaks. There are also some age and income limits: when you establish a Coverdell ESA, the beneficiary must be under the age of 18 or a special needs beneficiary, and the plan is only available to families below a specified income level. In order to contribute to a Coverdell ESA, individuals and married couples filing jointly must have adjusted gross incomes below $110,000 and $220,000, respectively.
Uniform Gift to Minors Act (UGMA) Accounts
Unlike 529 plans and Coverdell ESAs, parents don’t always use UGMA accounts to cover educational expenses. That’s because an UGMA account is, in the words of FINRA, an “old-fashioned custodial trust account.” A parent, grandparent, or any other adult who’s feeling generous is able to transfer money to an UGMA account for the benefit of a minor. Upon donating the money to the account, the donor chooses a custodian to act in the child’s best interests and make all investment decisions on his or her behalf until he or she reaches the age of majority, which ranges from 18 to 21 and depends on the laws of your state. The donor can act as the custodian, or the donor can appoint someone else to act as the custodian. Unlike other savings plans, it’s impossible to change the beneficiary of the UGMA account. If you’re the donor, that means you should be comfortable with the idea of using this money on your kid, even if he still mooches off your cell phone plan well into his 30s.
Once (or if) your kid gets his first job, you can open up a Roth IRA in his name. There are usually penalties for withdrawing earnings from a Roth IRA before the age of 59.5. However, those penalties go out the window as long as the money goes toward either a first-time home purchase or qualified education expenses. (Remember that there are some withdrawal limits in terms of the first-time home purchase penalty exemption.) This savings plan would probably work well for folks with kids who have no plans to attend college. At the very least, you can start making contributions that they can use to either buy their first house or get a head start on saving for retirement.
I hope you’re feeling a little less overwhelmed now that we’ve covered the different types of college savings plans. I know that the process of actually saving for college is probably the source of most of your worries. The costs of college continue to rise, so those are completely normal feelings. However, there are steps you can take now to make college at least slightly more affordable for your kids. The first step is to get off your butt and start saving. I know it’s tough to try to save for things like college and retirement when you probably have so many other crazy expenses to deal with, but trust me: you, and your kids, will be glad you took that first step.
Michael Armstrong is a partner and financial advisor with the Armstrong Advisory Group. He currently hosts The Financial Exchange Show alongside Barry Armstrong and Chuck Zodda. Learn more about Michael and the Armstrong Advisory Group by visiting www.armstrongadvisory.com. Securities offered through Securities America, Inc. Member FINRA/SIPC and Advisory Services offered through Securities America Advisors. Barry Armstrong, Representative. Representatives of Securities America do not offer tax advice. Always seek the assistance of a tax professional familiar with the laws in your state. Armstrong Advisory Group and Securities America are unaffiliated. October 2018
(Image courtesy of The Wall Street Journal)