As a parent, you naturally want to give your children every advantage to succeed in life. For many, this will include helping them with college — which is becoming more expensive every year. The good news is that you can begin saving for these expenses no matter what your child’s age. Perhaps the best-known way to do this is to set up a 529 plan.
The most common 529 plans allow you to accumulate savings in a tax-advantaged way. There is also something known as a 529 prepaid tuition plan, which allows a parent or guardian to purchase college credits today that can be used in the future, essentially “locking in” today’s (presumably) lower costs.
Both come with significant tax advantages — as long as the distributions are used to pay for qualified educational expenses or other forms of professional development. So for many families, setting up a 529 college savings fund makes the most sense. But it’s not the only option. Here are 3 alternatives to a 529 college savings plan you might want to consider.
COVERDELL EDUCATION SAVINGS ACCOUNT (ESA)
Available through brokerage firms, credit unions and banks, a Coverdell Education Savings Account (ESA), like a 529 plan, allows money to grow tax-free as long as you use the funds for qualified expenses. Unlike 529s, these accounts tend to offer parents and guardians a wider range of investments to choose from, including stocks, bonds, ETFs, mutual funds and CDs.
The drawbacks? You’re limited to a $2,000 annual contribution (per beneficiary), and if your income is too high ($110,000 for single filers, $220,000 for married couples in 2020), you will not be eligible to open an account. In addition, the beneficiary must use any accrued funds by the time he or she is 30 years old or will need to transfer the money to a new beneficiary or to a 529 account.
Uniform Transfers to Minors Act (UTMA) accounts and Uniform Gifts to Minors Act (UGMA) accounts are two types of custodial accounts you can open to save money for your child for any reason.
Your child is the ultimate owner of the funds held within these accounts; you act as the custodian of the account, managing the money until your child reaches adulthood and can take responsibility over the funds.
While Coverdell ESAs and 529 college savings plans offer tax benefits, UTMA and UGMA accounts do not. Contributions will not limit your income tax liability, and any appreciation in the assets will ultimately be taxed. Another point to know is that your Expected Family Contribution value, as determined by the information you provide if you apply for financial aid through the Free Application for Federal Student Aid or FAFSA, will likely be greater when you save in a UGMA/UTMA in lieu of a 529 plan or Coverdell ESA.
So why would someone choose to open one of these accounts? The main reason is flexibility: As long as the expenses are used to benefit the child, the funds can be used for anything. This means you’re not just limited to educational expenses and the minor has total control over the account assets after he or she reaches a certain age (which can range from 18 to 25, depending on the state).
A Roth IRA isn’t a college savings fund at all — it’s a retirement account funded with post-tax money. As with most tax-advantaged accounts, there are limits to what you can contribute. Currently you can add $6,000 into a Roth IRA ($7,000 if you are age 50 or older). As long as you don’t earn more than $124,000 in a year ($196,000 if you’re married filing jointly), the maximum amount you can contribute each year starts to go down; once you earn $139,000 ($206,000 if you’re married filing jointly), you can’t contribute to a Roth IRA.
So, how is it possible to use a retirement account to pay college expenses? Because you’ve already paid income taxes on the money you use to fund your Roth IRA, it’s possible for you to withdraw your contributions without paying penalty or taxes.
And because retirement assets aren’t generally taken into consideration when you apply for financial aid through the FAFSA — unlike 529 plans, Coverdell accounts, and UTMA/UGMA accounts — this strategy may help you maximize aid.
But just because you can use your Roth IRA to pay for your child’s college expenses doesn’t mean you should. While it’s noble to help your child pay for college, doing so at the expense of your own retirement may not be the best option. A financial advisor can work with you to identify your goals and help you build a financial plan that balances the things that are important to you in life.
No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested. This publication is not intended as legal or tax advice. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.