When your kids are still in diapers, going through the finer points of different savings plans for college probably isn’t high on your list. But the time when your kids are grown up and ready to leave for college will be here before you know it. So it’s never too early to start saving for college — even if you aren’t sure your wee one will eventually attend.
As college costs continue to skyrocket, starting early is the best way for your savings to grow. Fortunately, there are numerous ways to set up savings plans for college — even some that have tax advantages. Here are six options to consider.
SAVINGS PLANS FOR COLLEGE
While some of the specific plans have contribution limits, it’s important to point out that the yearly gift tax exemption rules apply to gifts to any of these plans. That means that if you’re contributing more than $15,000 as an individual ($30,000 if you’re married), you will either eat into your lifetime gift-tax exemption (currently $11,700,000 if single and $23,400,000 if married in 2021) or you will owe tax on any contribution that’s over the yearly exemption.
A 529 is a dedicated college savings plan that allows your money to grow in a tax-advantaged way. You won’t have to pay federal income taxes when you withdraw the money from a 529 as long as you are using it for qualified expenses, which include tuition, fees, class materials and more at any accredited college. (If you use the money for a non-qualified expense, you will owe taxes as well as a 10 percent tax penalty on the growth.) You can also use up to $10,000 per year to pay for tuition for grades K through 12.
Almost anyone can open and/or make contributions to a 529, which makes it a great way for you, or even other family members save for your baby’s future. Every state has its own plan, but you’re not limited to the one in your own state. However, some plans may allow you may reap additional tax advantages as a resident.
COVERDELL EDUCATION SAVINGS ACCOUNTS (ESAS)
Formerly known as an “Education IRA,” these plans offer tax-deferred savings and tax-free withdrawals when the funds are used for educational costs. It they’re not used for education, the money will go back to your child rather than the plan holder, giving you less control over how it’s used.
You can only contribute up to $2,000 per beneficiary per year, and even that is subject to income limits. For 2021, contributions are gradually reduced once your modified adjusted gross income (MAGI) hits $190,000 for married couples filing jointly or $95,000 for single filers; they phase out completely for those with a MAGI of $220,000 or more ($110,000 for single filers).
UNIFORM GIFT TO MINORS ACT (UGMA)/UNIFORM TRANSFER TO MINORS ACT (UTMA)
These “custodial accounts” can be used for many expenses beyond college, providing additional flexibility that can be attractive to parents who want to save for their child but don’t want to lock into a college savings plan. One key difference from other college savings choices is that the UGMA/UTMA comes with no strings attached: The account automatically transfers to the child at the age of 18 or 21 (depending on the state), which means that he or she can then spend the funds on anything they choose. In addition, unlike 529s and Coverdells owned by the parents, UGMAs and UTMAs will appear as assets of the child on the Free Application for Federal Student Aid (FAFSA), which affects their eligibility for aid more significantly than parent-owned assets.
Traditionally used as a retirement savings vehicle, a Roth IRA offers the benefit of savings that grow tax-free. Typically, you can withdraw direct contributions that you’ve made to the Roth RIA whenever you want, but you can’t withdraw earnings without paying a 10 percent penalty until age 59 ½, although there is an exception for qualified education costs if the plan has been open at least five years.
Since it’s not limited to college expenses, you can keep the money that your child doesn’t use for your own retirement. However, if you designate a Roth IRA for college savings, make sure you aren’t putting your own retirement at risk. Also keep in mind that annual contributions are currently capped at $6,000 if you’re under 50.
PERMANENT LIFE INSURANCE
If life insurance wasn’t already a key component of your financial plan, becoming a parent likely made you more aware of its importance. Not only will a whole life insurance policy provide a death benefit to your loved ones if you die too soon, but a policy purchased when your child is still a baby will accumulate cash value that you could eventually use to help pay for college costs. Another benefit is that life insurance isn’t counted as an asset when it comes to filing for financial aid.
An educational trust allows you to set funds aside and offer guidance on how the funds will be used, such as for a four-year college education or for any educational expenses, including trade school, community college or even travel. The money in the trust will be tax-free on withdrawal but you will pay taxes on the money earned by the investments; upon withdrawal it will be taxed at the beneficiary’s tax rate, which might be lower than yours. Additionally, any trusts set up to benefit the student will be reported on the FAFSA as a student-owned asset, which affects eligibility more significantly than parent-owned assets.