Four Ways to Save for College

The price of going to college has been steadily increasing since the 1980s.  An article in Forbes published a couple years back noted that the cost to attend a university increased nearly eight times faster than wages did during this time.  It is no wonder that saving and paying for college is a top concern for many of our clients.  Outlined below are the pros and cons of four college savings vehicles and some helpful tips to guide you in the planning process.

 

529 College Savings Plans

If you are a resident of Indiana, this is the number one vehicle to consider when saving for college.  It is hands down the best option, as the state of Indiana offers a tax credit of 20% on contributions up to $5,000.  For example, if you contribute $5,000 as a resident, you get $1,000 back on your taxes.  This is like you are receiving an instant 20% return on your investment.

Every state offers their own 529 plan.  Check to see if you get a tax credit or deduction for contributions to your state plan.  If so, it is likely best to open a 529 account in that state.  If not, then certain states’ plans are better than others as investment options and costs differ.  The important thing to note here is that you do not have to live in a certain state nor does your kid have to go to a certain university in that state to enroll in their 529 plan.

All growth that is earned in a 529 account can be withdrawn tax-free if used for qualifying educational expenses (and that list is quite long).

 

Pros: tax-free growth, potential state tax credit/deduction, easy rules, no income or age limits, beneficiaries can be switched to other family members, K-12 expense reimbursement eligible, eligible for certified Apprenticeship Program expenses

Cons: penalties on withdrawals if not used for education expenses

 

For a detailed write-up of 529s, check out this excellent write up by fellow advisor Josh Bentz: https://wealthpointadv.com/college-savings-season/.

 

Taxable Investment Accounts

What do you do if you are not 100% sure your kid will go to college or you are worried about overfunding a 529 account?  Here is where taxable investment accounts can come into play.  These are just your typical savings-like, brokerage accounts that you can use to invest in the stock and bond market.  It can be used for any purpose – 2^nd home, bigger home, new car, land, business, retirement, or college.  If not needed for college, then it can be used to fund any other goal or dream that you have outlined.    I personally only put $5,000 into a 529 plan each year to get the full Indiana state tax credit.  Any additional savings (outside 401(k) or Roth IRA) goes into a taxable account for potential college use.

 

Pros: fully flexible, easy to setup, no penalties if not used for college

Cons: taxes on earnings – dividend taxes and capital gain taxes at sale, no state income deduction

 

Roth IRAs

Roth IRAs are the ultimate retirement accounts.  I would take a $1 in a Roth IRA over $1 in a brokerage or traditional IRA account any day.  There are some interesting features of Roth IRAs that are worth noting, especially with regards to college planning.  Since contributions are made with after-tax money, all contributions can be withdrawn at anytime at any age with no penalty.  For example, if I contribute $5,000 per year for four years, I can withdraw $20,000 at any time.  There are a few 5-year holding rules on withdrawals of earnings that you’ll need to be aware of.  This penalty is waved if you withdrawal up to $10,000 in earnings to pay for higher education for a child or grandchild.

 

Pros: flexible, contributions can be withdrawn at any time – income tax and penalty free

Cons: annual contribution amount is low, income limits for high earners, no state income deduction

 

Coverdell Education Savings Accounts (ESAs)

Formally known as education IRAs, an ESA allows a family member to save up to $2,000 for a child to go to school.  All Coverdell funds can be used to pay for education expenses for grades K-12 as well as college.  Funds must be used by the time a student is age 30 or taxes, fees, and penalties will accompany withdrawals.

 

Pros: easy to establish, K-12 expense reimbursement eligible, tax-free growth

Cons: annual contribution amount is low, income limits, no state income deduction

 

Additional considerations

1. The SECURE Act that was passed into law in December 2019 states that money in a 529 plan can now be used to pay off student loans (lifetime max of $10,000).
2. Due to the high funding capabilities and the tax-deferred growth of 529 plans, some clients use this account as a legacy planning tool for future generations. As beneficiaries can be changed to different family members, these accounts can be passed down from generation to generation.

 

In summary, each situation is unique.  We generally lean toward leveraging the full advantages of 529 plans when planning for college but there are many options.  Just remember one thing – your child or grandchild can take a loan for college.  You cannot take a loan for retirement.  You can best help others only after you have first taken care of yourself.