The 18-year clock starts ticking the moment your child is born.
A college degree, despite the rising cost of tuition, remains a major achievement in the modern economy. You are more likely to have a job and earn a decent salary the more education you receive.
Yet many aren’t preparing. Just 56 percent of parents are actively saving for their child’s education, according to Sallie Mae, and hold an average of only $18,135. That wouldn’t cover one year of tuition, fees, and room and board at an in-state public institution, according to College Board.
The outrageous price tag for higher education, coupled with a lack of parental savings and the economic benefit of actually going to college, has led to historic levels of student loans. Many graduates leave school with a yoke tied around their neck, pushing back their ability to buy a house and start a family.
Following are several types of accounts people use to save for their children’s college, and what to know about each.
Many parents prefer to save for their child’s education with some kind of transaction account, such as a savings account or CD. According to Sallie Mae, college-saving parents have nearly $6,500 parked in these accounts, more than in a 529 plan, which represents 36 percent of all saved.
You need to be careful with these safe products.
“There is an asset protection allowance, or APA, that protects a portion of the parents’ assets, based on the age of the older parent,” when determining financial aid, says Mark Kantrowitz, publisher and vice president of research at SavingForCollege.com and an expert in student loans and financial aid.
Students’ income and savings, though, have a bigger, more negative, impact on the availability of financial aid than parental assets and income.
Because financial aid is determined based on income and assets from the year prior to applying for aid — in most cases, the student’s junior year in high school — students with sizable savings in their name could end up with a less generous package.
But even if the savings are in your name, you’re still losing out. The top 5-year CDs on Bankrate offer a yield of just over 3 percent, while the S&P 500 has delivered a total return of 13.4 percent over the past five years, according to Morningstar.
While you certainly take on more risk investing your money than simply putting it under your mattress, you may have little choice if you want to reach your savings goal.
529 college plans
Operating in a fashion similar to a Roth IRA, 529 college savings plans allow parents to invest after-tax money into diversified, low-cost stock and bond funds and then withdraw the money tax-free for qualified education expenses.
Some age-based investment packages work like a target-date fund in your 401(k) – contributions are placed in stock-heavy investments when the child is young, then automatically reallocated to a higher percentage of bonds and even cash as the child nears college age.
These plans offer big tax advantages, says Craig Parkin, a managing director at TIAA-CREF, the investment organization that administers state-sponsored college savings plans in California, Kentucky and other states.
“The gains on the accounts are tax-deferred, and once the funds are used to pay for qualified tuition expenses, parents will never pay taxes on those funds,” he says.
Money in these accounts can be used for undergraduate or graduate studies at an accredited two- or four-year campus in the United States. Savings in a 529 plan belong to the parent, not the child.
“A 529 college savings plan is considered a parent’s asset because the parent is the account owner and they can change who the beneficiary is,” Parkin says.
While you are taking on an investment risk, such as the fund dropping in value just as your kid enters school, you’re also making another gamble. What if your kid doesn’t want to actually go to college? What happens to the money then?
You do have some flexibility.
“If the child says they don’t want to go to college, the parents or whoever owns the account can change the beneficiary,” says Kelly Campbell, CFP professional and founder of Campbell Wealth Management in Alexandria, Virginia. “That way, you know the money will be used for education.”
One change in the recent GOP tax bill allows 529 plans to be used for non-college expenses, like a private high school.
Still, if you don’t actually use the money for education, you’ll be subject to a similar penalty for early withdrawal from your 401(k). 529 college savings funds can be withdrawn tax-free only for qualified education expenses, including tuition, books, fees, supplies, and room and board. Money spent on unqualified expenses is subject to income tax and a 10 percent penalty on earnings.
There are also restrictions on how money in these plans can be invested. For instance, account owners can switch the investments in their plan only twice a year.
Three in 10 parents use a 529, according to Sallie Mae, with about $5,500 saved. Unfortunately, that’s not nearly enough. Financial advisers recommend you save $300 to $400 a month to cover two years of public college costs.
Prepaid tuition plans
A prepaid tuition plan is an alternative to a 529 savings plan that may appeal to some parents. Designed for parents who are sure that their child will attend an in-state public university, this plan allows parents to simply pay for tuition credits in advance at a predetermined price.
Prepaid 529 plans retain the same tax, financial aid and parental protections as 529 college savings plans, but without being subject to swings in the stock market.
“The major limitation to a prepaid plan is that if the child decides to go to school out of state, they’ll get a return on their money, but they won’t get the full value of the plan,” Parkin says. “For example, if someone bought one year of tuition at a Kentucky state school for $12,000 and now tuition is up to $20,000, they would get a full year of college. If they decide to go to school in, say, Ohio, they would get a return — probably $13,000 or $14,000 — but they wouldn’t get the full $20,000.”
Like 529 college savings plans, prepaid plan holders can change beneficiaries at any time, but must pay a 10 percent penalty plus income tax on funds used for anything other than college tuition.
“You can have the prepaid plan to pay for tuition and a 529 college savings plan to pay for other expenses,” Parkin says.
UGMA and UTMA accounts
If your child doesn’t plan to attend college and therefore isn’t at risk of losing financial aid, UGMA and UTMA custodial accounts offer standard tax breaks for children under 18.
UGMA stands for the Uniform Gift to Minors Act. UTMA stands for Uniform Transfer to Minors Act.
In these accounts, the first $1,000 in gains is tax-free, the second $1,000 is taxed at the child’s income tax rate and the remainder is taxed at the parent’s income tax rate, according to the IRS. Plus, there are no restrictions on how the funds may be used as long as they directly benefit the child.
The downside of UGMA and UTMA accounts is that parents have less control over how the child eventually spends the money, says Michael Kay, CFP professional and president of Financial Life Focus, a financial planning firm in Livingston, New Jersey.
“If money is in a UTMA or a UGMA account, it becomes (the beneficiary’s) at the age of majority, which is 18 to 21, depending on the state,” he says. “There’s no legal way to prevent the child from using money that was intended for college or a house to go to Europe.”
That may be why these accounts are unpopular. Parents have less than $200 saved here, or about as much as they have in Bitcoin.
Finally, parents can give a kid a financial head start by opening a Roth IRA in the child’s name once he or she begins earning income.
While children over age 18 retain control of the account, restrictions on Roth IRA withdrawals keep investors from taking earnings out penalty-free until the age of 59 1/2.
However, there are exceptions to this rule that allow early withdrawals due to certain circumstances (hardships such as a disability) or for specific types of spending (such as purchasing a first home or for qualified education expenses).
A trust in the child’s name is another option for parents. However, these plans come with legal and administrative fees parents won’t face with a Roth IRA.