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Saving for your child’s education: Which accounts to use when

  • Prodigy baby in graduation cap and red ribbon reaching for apple

By Anh Thu Tran, MBA

As our society becomes more technologically advanced, we become increasingly dependent upon an educated workforce. Consequently, a good education is often critical to one’s success.

An article in U.S. News and World Report noted that it takes about $233,610 to raise a child. Believe it or not that daunting figure excludes college costs, which could require another $100,000 to $200,000 or more, depending on whether your child attends a public or private university.

Given the high cost of raising a kid, what can parents do to help pay for their child’s education? As with retirement savings accounts, the options for saving for a child’s education are varied. For those looking to assess which accounts are most appropriate for their family’s situation, below is a high-level overview of four key account types: 1) The Education Savings Account (i.e. Coverdell), 2) The 529 Plan, 3) The Uniform Transfer to Minor’s Account (UTMA) or Uniform Gift to Minors Account (UGMA), and 4) Roth IRAs.

COVERDELL (aka ESA)
Who Would Most Benefit Those looking to use tax free savings to help pay for child’s educational expenses in grade school, high school or college.
Contribution Limit
  • $2,000 for each child per year until child is 18.
  • Contributors must have Modified Adjusted Gross Income (MAGI) less than $110,000 (singles) and $220,000 (couples filing tax returns jointly).
Pros
  • Investments grow tax-deferred and withdrawals are tax-free for qualified educational expenses.
  • Fairly broad interpretation of qualified educational expenses.
  • Can withdraw money for grade school through college expenses.
  • Many investment options.
Cons
  • Low contribution limits.
  • Few institutions offer this type of account as many are phasing it out.
529
Who Would Most Benefit Families who want to save a significant amount for college and have the means to do so.
Contribution Limit
  • $14,000 per child per year (gift-tax exclusion) – singles.
  • $28,000 per child per year (gift-tax exclusion) – couples.
  • $70,000 with prepaid 5-year election – singles.
  • $140, 000 with prepaid 5-year election – couples.
  • Total limits range from $235,000 to $500,000 (non-prepaid plans).
Pros
  • High contribution limits.
  • No income limits for contributors.
  • Many institutions offer this type of account.
  • Investments grow tax-deferred and withdrawals for qualified college expenses are tax-free.
  • There’s less impact on potential student aid, especially if account is under parents’ name with child as beneficiary.
  • Leftover funds can be (re)designated to a beneficiary who is a family member (i.e., siblings).
  • Contribution may result in reduction in state tax (in some states).
Cons
  • Limited investment options. Lack variety and flexibility.
  • Big range in investment options from one plan provider to the next, state to state.
  • Some states may layer on additional administrative costs.
  • Some financial institutions have new account minimum investments of as much as $3,000.
  • Account owner takes investment risk. If invested too aggressively, balance could decline in value when needed to cover college expenses.
  • Can reduce financial aid eligibility.
Note While these accounts are administered by individual states, you can participate in 529 plans that are not sponsored by your state of residence. If your state offers an income tax deduction for contributions, it will likely make sense to use your state’s plan.
UTMA/UGMA
Who Would Most Benefit For kids who may not attend college.
Contribution Limit
  • $14,000 tax-free per child per year (gift-tax exclusion) – singles.
  • $28,000 tax-free per child per year (gift-tax exclusion) – couples.
Pros
  • Wide range of investment options.
  • No penalty for using funds to pay for non-educational expenses. Funds may be used for any purpose that benefits beneficiary.
  • First $2,100 of earnings and gains are taxed at child’s rate. Subsequent amounts are taxed at parents’ rate.
  • Transfers from custodians (parent/parents) to child are treated as gifts.
Cons
  • Minor takes ownership between age 18-21, depending on state’s definition of adulthood. Consequently, custodial account owner loses control of funds.
  • Once child takes over assets, they are considered his/her possession and so are counted less favorably in terms of financial aid eligibility.
  • Contributions are irrevocable, and custodians cannot transfer to a different beneficiary.
ROTH IRA
Who Would Most Benefit Families who want more flexibility in how funds will be used – education or retirement.
Contribution Limit
  • $5,500 for those under 50 years old and $6,500 for those over 50 years old
  • Contributors must have MAGI less than $133,000 (singles) and $196,000 (couples filing jointly).
Pros
  • Many investment options.
  • Assets grow tax-deferred, and withdrawals after age 59½ and after holding for five years or more are tax-free.
  • Money not spent on education can be used for retirement.
Cons
  • Relatively low contribution limits.
  • Competing uses for funds – education or retirement. (NOTE: While one can take out a loan for an education, one cannot do so for retirement. By using Roth IRA assets to pay for an education, parents may be depriving themselves of decades of tax-free growth and withdrawals.)
  • Distributions are counted as income the year after they are taken out. This is important to note for financial aid timing/purposes.

Aside from saving for retirement, saving for a child’s education is the next biggest savings goal for many parents. It’s important to be proactive:

  • Know your family’s financial situation.
  • Acquire a working understand of which accounts best fit your situation.
  • Invest early and often, after funding your own retirement savings.
  • When it comes to paying for the college years, understand how to most efficiently mix financial aid opportunities with tax credits and withdrawals from accounts.

 

It’s not cheap to send a child to college. However, the overall experience and potential financial return (in future salaries) are likely to exceed tuition cost.

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