College costs are hard to ignore. Horror stories of young adults graduating with life-changing levels of debt becoming commonplace and tuition costs rising faster than the rate of inflation. Parents who want to support their children through college are increasingly questioning whether they can do anything that will make a difference when their child reaches college age. Major financial goals are best achieved through steady action. You may not be able to control national trends in college costs. However you can control how much money is set aside, the tax advantages you make use of, and the cost of the college you attend. With so many savings options to consider, two stand out as the best way to save for college.
Coverdell Educational Savings Account (ESA)
These accounts are tax-deferred and work the same way as your employer-sponsored 401(k). You can contribute up to $2,000 per year into these accounts. Taxes will be due only when money is withdrawn from the account to fund expenses that are not related to education or when the student fails to use the money by the time they are 30. If the money is subject to taxes, the gains are taxed at the student’s lower income tax rate.
ESAs are a great option, but only families who fall below a designated income level qualify for them. Why are they so great? Imagine that you contributed $2,000 a year for 18 years into an account. If the money was invested into a simple low-fee S&P 500 index fund that returned 8% on average, the account would be worth over $80,000 when the student was ready to go to college. The contributor would gain a valuable deduction every year they contributed, and the student would have a well-funded, tax-free college fund. Think your account will perform better? Here is a helpful simple return calculator you can use for free.
Afraid your student won’t seek out higher education? ESAs can be used to fund K-12 expenses, like school supplies and uniforms. They really are one of the best available savings options around!
If you don’t qualify for an ESA or want to save more to support your child as they go through graduate school, use a 529 savings plan. These plans operate like Roth IRAs and allow family members to set after-tax money aside. Once invested in the index or mutual funds, the money will grow tax-free and can be withdrawn to fund any qualified educational expenses. Whether that is trade school tuition, rent, books for graduate school, or any number of other qualified expenses does not matter.
What is so great about the plans? First, they’re purpose-built investment options. Unlike Roth IRAs or UTMA accounts, the student does not need to have an earned income to qualify for the plan and they can be fully funded from the moment your child is born. Second, anyone can fund them to support your student. Grandparents, uncles, and other family members are free to make a meaningful impact on your child’s life through the 529 plans. Finally, the money stays in your control. If financial circumstances, life choices, or other factors make the financial gift inappropriate, the plan sponsor can roll the money to other siblings without penalty or can withdraw the money, pay a penalty, and keep it in their name.
529s are also exceptional tools if you plan on using financial aid to cover at least some of your higher education expenses. Current guidelines heavily favor 529 plans and only assess them at 5.64% when determining Expected Family Contribution (EFC) levels. This means that a family qualifying for financial aid with $10,000 in a 529 would only see their EFC increase by $660, while a similar family that used a savings or investment account to provide the same amount of money would be disqualified for a larger portion of aid. Want another reason to love 529s? Accounts held by family members have no impact on financial aid.
Considering other options? Speak to a qualified financial advisor to consider whether a non-conventional savings method makes sense for your family.
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