It’s always a good time to start saving for your kiddo’s education expenses, as they are sure to be massive. While you could just sock your money away in a typical savings or investment account, there are a few types of accounts specifically designed for kiddos, which can give you a nice tax advantage. Let’s take a look at the options.
529 savings plan.
A 529 savings plan is a college savings account which is sponsored through a U.S. state. It is very similar to a mutual fund in that you are limited to certain investment choices, but also offers tax benefits as long as the money is used for qualified education expenses.
Benefits of a 529 college plan include:
- Withdrawals are tax free, as long as they are used for college.
- You can use the money for any college.
- You can use the money for many postsecondary programs including trade schools.
- Funds can be used not only for tuition but also for books, fees, and housing.
- Contribution limits are high. (These are set by the state, but can be as high as $380k. Note however that gift tax may apply for contributions over $14k in one year.)
- There are no income limits.
- Some states offer a tax deduction — or better still, a credit — for plan contributions.
- You can sign up for a plan outside of your home state, if it suits you better.
- You can transfer the money to a different state’s plan at any time.
- You can transfer the money between family members — so if little Jane decides college is stupid you can transfer the money to little Dick instead.
- If both Dick and Jane decide college is stupid (maybe they’re twins?), you can use the money for that boat you’ve had your eye on. You’ll just pay a 10% penalty plus income tax on the earnings.
- You can make investment changes up to twice a year.
- New contributions can be directed to any investment option.
- Contributions fall under the asset protection allowance, typically around $20-$30k.
- If your child receives a scholarship, you can take out any amount up to the value of the scholarship with no penalty.
- Contributions can be made even after the child turns 18.
- Control always remains with the account holder. So don’t worry about little Dick using it to buy a drum kit along with that vintage Stratocaster he’s had his eye on.
There are a few drawbacks, though:
- Can be used for college and postsecondary school expenses only.
- Any money which is withdrawn and not used for college is subject to a 10% penalty + tax on earnings.
- Any money left over after paying for tuition will be penalized and taxed.
- You are limited to specific funds, which may have high expense ratios.
- Any lump-sum contributions over $13k per year are subject to a gift tax, although in most cases you won’t pay any tax as there is ~$5MM exemption — but you do need to file a form.
For a comparison of 529 plans, check out this Savingforcollege.com guide.
529 pre-paid tuition plan.
If you have your heart set on a specific school, this plan is worth a look. It allows you to buy college credits at a set rate (which may or may not reflect current prices), which could amount to savings considering that tuition costs are going up at a rate of almost 10% a year. Pre-paid tuition plans also offer the same kind of tax advantages and other 529 plans.
- There are two types of pre-paid plans: public, and private. Public plans can only be used for in-state public colleges, and private plans can only be used for private colleges which are a member of the plan.
- Pre-paid plans can be more secure that regular 529 plans as they are not subject to stock market fluctuations.
- The amount that your credits are worth may be opaque or estimated, so it can be hard to tell how much you need to save.
- There is some amount of risk however, in that not all plans are guaranteed by the state. So, if the plan administrator is running short on cash, your payout may be affected.
- It’s important to read the fine print as you may be on the hook for tuition increases if they rise significantly, or, in the case of a funding shortfall, you may be liable for the difference.
Given all of the risks and limitations, I would not recommend a pre-paid tuition plan for most people, unless you are certain that your child will attend either a specific university, or stay in-state.
A Coverdell ESA (aka education savings account, formerly known as an Education IRA) is similar to a 529 plan, with a few key differences:
- Flexible investment choices — you can invest in just about anything except for life insurance contracts.
- Can be set up at just about any financial institution.
- Money can be used for private school as well as college.
- Contributions are limited to $2k per year total (including contributions from other family members).
- Contributions are phased out based on gross income (MAGI). See IRS publication 970 for details.
- You cannot make any contributions once the beneficiary turns 18, except for special needs children.
- The age at which your child gains control of the account can be flexible. In all cases the funds must be distributed to them when they turn 30.
A custodial account is a very simple savings or investment account which is managed by a parent or other custodian, on behalf of a child. However, a custodial account has no tax advantages and has other drawbacks, so is not a great option for most people. Some differences between a custodial account vs an ESA and 529 include:
- Ownership transfers to the child between the age of 18 and 21.
- There are no contribution or income limits.
- There are no withdrawal penalties.
- The money belongs to the beneficiary, and cannot be transferred or used for other children (although you can transfer it to an eligible 529 plan).
- Funds can be transferred to a 529 plan (non-cash investments must be liquidated first, however).
- The account is treated as an asset and so may affect financial aid eligibility.
- Income in excess of $1k a year may require that you file a tax return for your child, and pay tax — although if the income is limited to interest, dividends, and capital gains distributions, then you may be able to include it on your own tax return. See IRS form 8814 for details.
- Investment income above $2k may be subject to a ‘Kiddie Tax’, which taxes the income at the parent’s higher rate.
Choosing the right plan.
For most people, the best plan will be either a Coverdell ESA, or a 529. Personally, I like the investment flexibility of the ESA, so I would choose that — especially if your contributions will be $2k or less per year.
One thing to keep in mind is that you can combine plans. For example, could start with an ESA and then add a 529 plan if you have additional contributions.
Which ever plan you choose, the important thing is to start saving as soon as possible. Every plan should allow you to automatically contribute monthly, which is the easiest and least painful way to ensure that you are properly funding the account. If you can, set aside $100-200 a month to start, and scale it from there.