The cost of a college degree can be high, but so is the value it provides. Over the course of their lives, college graduates can earn up to $1 million more than high school graduates. If you have children or plan on having them, and you hope that those children will one day pursue a college education, the time to start saving is now.
You have several options for saving for your child’s college education. Some savings programs are designed specifically for the costs of college, such as 529 plans and Coverdell Education Savings Accounts. Other ways to save aren’t specifically designed for educational expenses, but they can still be effective. Take a look at your options and weigh the pros and cons of each.
529 plans were specifically created to help parents and students save for college expenses. The plans are named for the section of the IRS code that details the tax advantages associated with them. When you open a 529 plan, the money in the account grows tax free. If you end up using the money in the account to pay for college, you do not have to pay tax on the earnings. The investment plan may involve investment risk.
529 plans are sponsored by states and each state, plus Washington, D.C., has at least one plan. Pennsylvania has two 529 plan options: the Guaranteed Savings Plan and an Investment Plan. Contributions you make to a PA 529 plan are deductible from your income for PA taxes.
The Guaranteed Savings Plan (GSP) is a type of prepaid tuition program. You contribute enough to pay for a semester of school at a particular level of college or university, such as community college or private four-year college, and it will be enough to pay for a semester at that school in the future, whether the future is ten, 15, or more years in the future.
When you open a GSP, you can select a tuition level, such as private colleges or state schools. You’ll then be told how much you need to save based on the tuition level you choose. You have the option of changing the level in the future.
Although a GSP can help you “lock in” a tuition rate, one drawback of it is that not every school is covered under it. If your child ends up deciding to go to a school that doesn’t participate in the plan, it can affect the value of your savings.
The PA 529 Investment Plan offers more flexibility than the GSP in terms of what you can invest in and the potential for growth. The value of your savings is not connected to where your child decides to go to school when you choose the investment plan option. The risk of a 529 investment plan is that, like any other type of investment, there is the chance that your account will lose value based on how the market performs.
One last thing worth noting about 529 plans is that although they are sponsored by the states, you aren’t limited to investing in your state’s plan. It can help to shop around and compare plans in various states to see which ones offer the greatest benefits.
Once called an education IRA, a Coverdell Education Savings Account (ESA) is a type of custodial account that exists to pay for the education expenses of the beneficiary. When you open a Coverdell account, it must be created for a person who is under the age of 18, and it needs to be designated as a Coverdell ESA at the time of creation.
Along with using the money in the ESA to pay for college, you can also use the funds to cover the costs of K-12 education.
A drawback of a Coverdell ESA is that it has a low annual maximum contribution. You can only contribute $2,000 per year per beneficiary to the account. Contributions aren’t tax deductible, but you won’t have to pay taxes on the earnings, provided you use the money to pay for the beneficiary’s education. The money in the Coverdell needs to be used to pay for education by the time the beneficiary turns 30 or else it will lose its tax advantages. You do have the option of transferring the account to another beneficiary if one of your children decides not to go to college or ends up not needing all of the money in the Coverdell.
A Roth IRA is typically used to help people save for retirement. But if you have a retirement plan through your employer and are on track to reach your retirement goals, another way to use a Roth IRA is to save for your child’s education expenses. You can take distributions from a Roth IRA before you hit retirement age (59 ½) to pay for qualified educational expenses, without paying the 10% penalty tax. If you are over age 59 ½ when your child goes to college, you can use the money in the IRA however you like without worrying about a penalty.
If you decide to open a Roth IRA to help your child save for school, you can contribute up to $6,000 each year (or $7,000 if you’re over age 50).
However, not everyone is eligible for a Roth IRA: Depending on your income, you might earn too much to open one or contribute to one.
Another way to save for your child’s education is to invest the money in mutual funds, outside of a Roth IRA or 529 plan. If your income is too high for a Roth, investing in mutual funds in a separate investment account can be a good option for you. You can pick whatever funds you’d like, and you can invest as much as you would like. You do have to pay tax on any earnings from the funds.
There are some risks of investing in mutual funds, though. Your investment could lose value based on how the market performs. Investing in mutual funds outside of a retirement or college education savings plan also means that you miss out on tax benefits, such as not paying income tax on the earnings.
You can also save money for your children’s future by opening either a Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA). Both are custodial accounts that hold money for children until they reach the age of majority. Although your children can’t access the money in the trust until they are adults, most of it is taxed at their tax rate, rather than at your tax rate (which is likely to be considerably higher).
The main difference between an UGMA and UTMA account is the type of assets that they can hold. An UTMA account can hold almost any kind of asset, including real estate or even a car note. An UGMA account is limited to financial products only, like bank deposits, stocks, bonds, mutual funds and other securities.
Money in a UGMA or UTMA isn’t restricted to being used for educational purposes, which can be a good thing or a bad thing, depending on your perspective. If your child doesn’t end up going to college, they can still access the money you’ve saved for them and can use it to launch a business or start their adult lives.
Both types of accounts are irrevocable, which means that once the gift is made, it cannot be revoked.
While the funds in UGMA or UTMA can be used however the beneficiary would like, the funds in an educational trust must be used however the grantor has set it up, so the funds may or may not be limited to education-related expenses. Educational trusts don’t necessarily offer the tax advantages of 529 plans, Coverdells, or Roth IRAs, but they do give the person creating the trust a higher level of freedom. For example, you can determine when the trust takes effect (while you are still alive or after your death). You can also decide what becomes of the money in the trust if the beneficiary doesn’t use it all to pay for school or doesn’t use it by a certain date.
If you’re interested in creating a trust for your child, consult with an attorney to get a better understanding of what is involved and what the tax consequences might be for you or the beneficiary.
It’s never too early or too late to start saving for your child’s future. PSECU offers IRAs, Coverdell ESAs, and investment options to help you put money aside for college and to help your children get off to a great start in life.