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Planning to Pay for Higher Education

Paying for your child’s college education is likely one of the most expensive events for your family. Rising tuition costs, which often mirror or exceed the rate of inflation, can make the education planning process seem daunting. Even if you haven’t had the discipline to save, all is not lost. Here are some practical tips to help you achieve your college savings goals.

Start saving early.

It’s not hard to figure out that the earlier you start your kids’ college funds, the better your chances of reaching savings goals. By starting sooner than later, you’ll have time–and compounding gains–on your side. Additionally, the longer your time horizon for saving, the less impact market volatility may have on your investment portfolio.

Don’t bank on financial aid.

Some parents assume that their children will receive financial aid, so saving isn’t a priority. Because most financial aid comes in the form of loans, that strategy can end up saddling your child with substantial debt. As a general rule, saving money with even a modest return makes more financial sense than borrowing and paying interest. There are also many factors that determine whether or not you qualify for financial aid, including your assets, income, and number of children attending college. Your financial advisor can help you assess your situation to determine the right balance of savings and forms of financial aid.

Decide how to save.

You have several options for education savings. Here are the main features of the most popular types of college funding accounts:

529 Plans

  • A tax-advantaged college savings plan named after section 529 of the IRS code

  • Individual states sponsor 529 plans and investment management is usually outsourced to an investment company

  • Can be used to pay qualified education expenses, including tuition, fees, and room and board

  • After-tax money grows free from federal–and often state–taxes and qualified withdrawals are also tax-free

  • There are no age limits or income restrictions to start a plan, and the account holder stays in control of the money

  • Contributions can’t be more than the amount needed to pay for the beneficiary’s qualified expenses

  • If your kid decides not to attend college, you can transfer the account to a sibling

  • Investment choices can be limited, and you can only rebalance the portfolio twice a year

Coverdell Education Savings Accounts (ESA)

  • Originally known as an Education IRA and renamed after the late Senator Paul Coverdell

  • Can be used to pay qualified education expenses in not only colleges and universities, but also elementary and secondary institutions

  • Like the 529 plan, ESA money grows tax-free and distributions for qualified education expenses are also tax-free

  • Accounts can be started by those with annual modified adjusted gross income of less than $110,000 ($220,000 for a joint return)

  • Contributions can be made up to $2,000 per year

  • May offer a wider range of investment choices than 529 plans

Custodial Accounts (UGMA/UTMA)

  • Accounts that allow transfer of gifts to minors under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act

  • Investments are held in the minor’s name, but managed by the custodian (i.e. parent), until the child reaches age 18 or 21, depending on the state.

  • Income is reported on the child's tax return and taxed at the child’s rate

  • Money can be withdrawn for any purpose, without having to get permission from the custodian, when the beneficiary is a legal adult

  • The funds are not transferrable to another beneficiary

For complete information about plan guidelines and qualified education expenses, consult IRS Publication 970.

Think twice about raiding other accounts.

You may be tempted to take money from your Roth IRA or other retirement accounts to pay college expenses, but this shouldn’t be considered a viable option unless you’re well funded for retirement. If you have more than enough retirement savings, you can consider taking money from a Roth IRA because of its tax- and penalty-free withdrawals that can be used for higher education. People also consider tapping cash value life insurance for education expenses, but this is rarely a good idea, due to high surrender charges and low investment returns related to these policies. Your best bet is to consult your financial and tax advisors about these options because there’s usually a wiser alternative.

Cover all your bases.

  • When you’re in a time-crunch to come up with money for college, make sure you’ve thought of every last-minute strategy:

  • Dig out those savings bonds that may have been overlooked

  • Increase your savings by sticking to a personal budget [link to budget article]

  • Consider less expensive colleges or take advantage of military education benefits, if your child completes active duty

  • Encourage grandparent gifting, especially when it comes to 529 plan gift-tax advantages

  • Steer your child toward working during college to offset some of the costs

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