How To Save For Your Child’s College Education
To state the obvious, the cost of education is extremely high. According to Vanguard’s college cost calculator, the projected cost of a public 4-year college (in-state) 18 years from now will rise from today’s cost of $88,720 to $230,070! In today’s post, I will talk about the various ways you can save for your child’s education and what I’ve chosen to do for mine.
Methods To Save For College
There are many options to save for your child’s education. While that’s usually a good thing, having many options can be overwhelming. Hopefully this section will give you a good overview of the various methods available to you and which one(s) make the most sense for your situation.
1. Let your kid pay for college themselves
I don’t believe in this approach, so this is a nonstarter for me. But I know there are plenty of parents out there that believe their kids should be fully responsible for their education costs.
We’ve all heard about the trillions of dollars in student debt Americans alone have accumulated. I certainly don’t plan to let my child add to that statistic. Coming out of college with no student debt was a huge blessing for me and provided a major boost to my financial situation. I want to give my child the same privilege.
2. 529 Savings Plan
Like a Roth IRA, a 529 Savings Plan is an investment account that allows your contributions to grow tax-free. That means that withdrawals for qualified expenses (tuition & fees, books & supplies, computers, room & board) are not taxed or penalized. If you make non-qualified withdrawals, however, your earnings (not contributions) will be taxed as ordinary income and have a 10% penalty. Some states will tack on an additional penalty on top of the federal 10% penalty.
529 Savings Plans are offered by the state and isn’t a federal program. You can select any state’s 529 regardless of which state you reside in. However, some states do offer a partial income tax deduction for their residents, so look at your own state’s 529 benefits before looking at others.
Each state determines the annual contribution limit. However, you shouldn’t contribute more than $15,000 per beneficiary, per year, due to the federal gift tax law. That is, if you gift a specific person more than $15,000 in a single year, you have to pay taxes on the amount above that $15,000.
Here are some other considerations:
Unlike some investment accounts like a Roth IRA, you can contribute to a 529 regardless of your income level.
You don’t have to be the only one contributing to your child’s 529. Oftentimes, 529 plans have a nifty feature where you can easily send a link to a friend or family member to contribute to the plan if they’re interested!
Lastly, 529 Savings Plans are no longer just for college expenses; you can use them to pay for up to $10,000 in private K-12 tuition and fees per year!
What happens if your child receives a scholarship?
Great! You can make a non-qualified withdrawal up to the scholarship amount without being penalized. However, you will have to pay income taxes on any earnings (again, not on contributions since contributions were made with your after-tax dollars).
What happens if you “overfunded” your 529?
First off, don’t panic. Overfunding likely means you’re in a solid financial position. This situation comes up for a variety of reasons like:
Your child finished college early and you have leftover funds
Your child didn’t go to college or won’t finish it
You literally invested too much or your investments grew more than anticipated
So what now? Well, you have a few options to choose from:
529’s are very flexible when it comes to designating who the beneficiary of the plan is. In fact, you can change the beneficiary to pretty much anyone related to your child, including any of their siblings, yourself, their own children (your grandchildren), or any other relative.
You can leave the funds in their name in case they decide to further their education in the future.
Take the 10% penalty and get taxed on the earnings portion.
3. Coverdell Education Savings Account (ESA)
Similar to 529s, a Coverdell ESA (Education Savings Account) is an account specific for educational expenses, and you don’t pay taxes on the earnings or qualified withdrawals. You can actually use this account to pay for qualified K-12 and college education expenses, even for public schools.
Here are some of the big differences between a Coverdell ESA and a 529:
For joint filers, the max you can contribute to a Coverdell ESA is only $2,000 per year.
You cannot contribute to a Coverdell ESA if your joint income is $220K or higher. If your joint income is between $190K and $220K, the amount you can contribute is reduced.
Once the beneficiary of the Coverdell ESA turns 30 years old, you must distribute all funds. But like a 529, you can change the beneficiary to another family member as long as they are under 30.
4. UTMA/UGMA
UTMA/UGMAs are custodial accounts that a guardian sets up on behalf of the child. Any money that’s contributed into the account is legally theirs. While they can’t touch that money until they’re between the ages of 18 and 25 (depending on the state), once they reach that age, they can technically use that money for anything. It is not designated specifically for education purposes. And if you think you can simply change the beneficiary to another family member, nope! Sorry! The account can’t be transferred whatsoever; it permanently belongs to the original minor you opened it for.
Unlike 529s, UTMAs don’t have any contribution or income limitations. You can contribute as much as you’d like. And unlike the Coverdell ESA, your child doesn’t have to use the money by a certain age.
5. Roth IRA
Traditionally, Roth IRAs are used for retirement. But technically, if you take an early withdrawal from your or your spouse’s Roth IRA before 59 ½ specifically for educational expenses, the 10% early withdrawal penalty is waived. Note that the earnings portion of the withdrawal is still subject to ordinary income taxes.
Roth IRAs have a max contribution limit of $6,000 per year, per person, as long as your earned income is at least $6,000 or more. If you earn more than a certain dollar amount, your contributions may be limited (or completely prohibited), so beware of this limitation. If you run into this income restriction, you may be interested in a Backdoor Roth IRA instead.
6. Pay out-of-pocket
This one’s straightforward. Just save money and/or invest in a regular taxable brokerage in your own name over the years and pay for your child’s education entirely out-of-pocket. Do I recommend it? Not at all. If you’re planning on paying for part or all of your child’s education, why not take advantage of one of the tax-advantaged options? To me, it’s a no-brainer.
Which Method I’ve Chosen
What: I’ve chosen to use a 529 for my child’s education.
Why:
Its earnings grow tax-free, and qualified withdrawals have no penalties.
It’s specifically earmarked for education and can’t be blown away on anything once my child turns 18 like they would be able to with an UTMA.
If I happen to overfund it, my child can hold onto it for future educational purposes or until they have children of their own and decide to pass it down.
I don’t like the Roth IRA option because that money is supposed to be for my future retirement. Because I’m in a sound financial position, I can both max out my Roth IRA for my retirement and fully fund a 529 account. That way, I can just use the 529 for my child’s education and don’t have to jeopardize my Roth IRA retirement funds.
How: I am currently “underfunding” in the early years and will pay the difference out-of-pocket once my child is close to 18 and ready for college. At the moment, I am auto-investing $500 per month into the account.
When: I took advantage of the 529’s flexibility in being able to change the beneficiary between family members easily. Before my child was born, I designated the beneficiary to be me. Then once my child was born, I changed the beneficiary to their name. Why? Due to the powerful effect of compound interest, the sooner you invest, the better the results (and the less amount of money you need to invest overall).
Where: I decided to select California’s 529 Plan. I did shop around other states to see if they offered anything better (you can pick any state’s plan without having to live there and use the funds for college in any state). While there were some really great plans out there, long story short, I narrowed it down to California’s and New York’s plans. Then I picked California since that’s where I live (not that there are any tax benefits), and I liked their funds.
Other Considerations
When choosing which route to save for your child’s education, accounts that are specifically designated for education purposes are subject to the $15,000 annual gift tax exclusion rule. That means that if you contribute more than $15,000 per person, per year, the amount over $15K will be subject to gift taxes.
However, the 529 has an exception to that $15K annual limit. You are allowed to pull forward 5 years’ worth of the gift tax exclusion (so up to $75,000) in a single year without penalty. This is considered “front-loading” your investment. Historically, front-loading any investment like a 529 will reduce how much you’d have to contribute overall. You can front-load every 5 years, so if you do it in year 1, you won’t be able to contribute to the 529 again until year 6.
A few other things I’ll quickly mention, and you can Google later:
Friends & family can contribute to a 529 very easily. Their contributions are restricted by the $15K annual gift tax rule, too.
For the 529, there are technically 2 routes you can take here: (1) the savings plan that I’ve referred to throughout this post, and (2) a prepaid tuition plan where you pay in advance at designated schools. The risk here is, “What if your child doesn’t go to one of the designated schools?”
Financial aid qualification can be impacted by some of these accounts, but it may not be as much as you think.
Conclusion
The 529 Savings Plan is how I’m saving for my child’s education. By auto-investing $500 per month for 18-19 years, I calculate that it should easily grow to $200K+. Because I’m well on my way to reach my $10M by 40 FIRE goal, if college costs any more than what’s in the 529 account by then, I shouldn’t have difficulty covering the difference out-of-pocket. It’s certainly not ideal, but I also don’t want to overfund the account.
Two things I may change in the future include: (1) front-loading money into the 529 instead of auto-investing $500 on a monthly basis, (2) increasing the monthly contribution to increase the ending balance when my child reaches college age. It won’t be the end of the world for me if the account is overfunded, and as my child gets closer to college age, I should have a much better idea of what it’ll cost to attend. So in the years leading up to the start of college, I may readjust my contributions depending on what the 529 balance is at that point.
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Do you plan on paying for part or all of your child’s education? If so, how are you saving for it? Share in the comments below!
