5 Common Ways Parents Save For Their Kids’ Education
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Like most parents, you would want your child to get the best education possible. But at the same time, you also know how much of a burden the cost of education in America can be. According to a 2020 report published by EducationData.org, the average cost of college in the country is approximately $32,889 per student. The costs have doubled in the last 20 years, growing at an annual growth rate of 5.2%. Yet many parents are not prepared. Sallie Mae states that only 56% of American parents are vigorously saving for their child’s education. These parents have average savings of $18,135, that are not sufficient to cover even one year of tuition, room fees, etc. So, if you have not begun planning for your child’s future yet, you must start now.
Here are five common ways you can use to save for your kid’s education:
1. 529 college plan
529 plans are state-sponsored, tax-advantaged plans that are ideal to cover higher education costs. In this plan, you invest your after-tax money into bonds and low-cost stocks for optimum diversification and withdraw your money tax-free for eligible education expenses. Qualified education costs include tuition, room, board, books, etc. However, if you take your funds for any non-qualified expenditure, you need to pay a 10% penalty. That said, each U.S. state has different rules for a 529 college plan. You can choose to place your savings in your state’s 529 education plan or any other state’s policy, depending on the benefits. But it is advisable to open a 529 plan sooner than later.
According to the College Savings Plan Network, the 529 savings plans rose to an all-time high with $352.4 billion in assets by the first half of 2019, signifying the importance of this plan. And even though the COVID-19 situation reduced the balance of the 529 plan to a $293 billion mark in March 2020. The plan is expected to pick up soon because of its numerous advantages. Some of the benefits of 529 college plans are:
- Tax deductions, tax-free money growth, and tax-free withdrawals
- Flexibility in beneficiaries. Parents can change the designated beneficiary in the future to cater to another child’s education.
- High contribution rates. Even though there is no annual limitation on contribution, the 529 plan balances cannot be more than the expected cost of qualified higher education. That said, each state has a different limit, ranging between $235,000 and $529,000.
- Option to roll over the 529 account savings into an ABLE account to support the non-qualified expenses of disabled kids and young adults.
However, you must assess your qualified expenses and be careful with the withdrawal rules of the 529 plan. It is also advised to apply well-in-advance for the withdrawal.
2. Roth IRA
Roth IRA (Individual Retirement Account) is a special retirement account for saving money for the future. Using the Roth IRA account for both purposes – retirement and education, offers numerous benefits and flexibility. In this account, you only pay taxes on the money you deposit. After this, all withdrawals are tax-free. Hence, these accounts work best for your child’s future, as well as retirement, because you invest your after-tax dollars and may pay lower taxes in the present than in the coming years. Moreover, since your after-tax contributions grow tax-free, your reserves get the maximum growth potential. Some advantages of securing money in a Roth IRA include:
- Tax-free growth
- Flexibility in the usage of funds once education expenses are paid
- Longer tenure for the funds to grow due to strict withdrawal rules until the age of 59.5 years.
However, you must check your Roth IRA eligibility and contribution limit before you consider this option for your kid’s education. For 2020, the maximum contribution you can make to a Roth IRA is $6,000 annually. However, if you are 50 years or more in age, the contribution can be $7,000 annually. The contribution allowance is only on earned income. This includes salary, wages, commission, bonus, freelance, business income, etc. Moreover, $6,000 and $7,000 are the upper limits for one or a combination of Roth IRA accounts. In case you make contributions above this criterion, the IRS (Internal Revenue Service) will levy a penalty of 6% every year until the error is corrected.
3. Coverdell education savings account
A Coverdell education savings plan is very similar to a 529 plan. This tax-deferred trust account allows parents to fund their child’s college as well as, elementary and secondary school education costs. Like a 529 plan, even a Coverdell savings account allows you to make after-tax contributions. Moreover, savings in this account grow tax-free, and the distributions are not liable for income tax, provided the money is used for qualified education purposes. However, unlike a 529 plan, a Coverdell education savings account is more flexible in terms of qualified expenses. This plan allows withdrawals to cover primary and secondary school tuition fees, uniforms, tutoring, and other K-12 costs without incurring any penalty. Some of the advantages of choosing this account are:
- Tax-free growth
- Wide variety of available investments
- A more extensive definition of qualified expenses
However, you can only save $2,000 every year in this account until the beneficiary is 18 years old. Additionally, your eligibility is constrained by income limitations. And you must comply with specific rules like all assets need to be distributed to the beneficiary by the age of 30 to avoid any tax penalties.
4. 529 prepaid tuition plan
As per a College Board report, every year, college tuition fees rise by nearly 5%. Tuition fees are one of the most draining educational expenses, hence a good way to secure money for your kid’s education is to choose a 529 prepaid tuition plan. This plan allows you to pay in advance, all or a part of the costs of education of a specific university or a group of institutions. The objective is to pay now and avoid tuition price hikes in the coming years. Some advantages of choosing 529 prepaid plans include:
- Tax–free growth
- No income or age restriction limits
- High contribution rates (vary by each state)
- Flexibility to choose and change the beneficiary in the future to benefit another child or even yourself
- Assurance of funds
However, because these prepaid plans are specifically for educational expenses, they can become disqualified if your child chooses not to go to college or gets a full scholarship. That said, you could either change the beneficiary in such a case or pay a 10% penalty and withdraw the funds.
Another common way that many parents use to save money for their kids is an educational trust. You can set up a trust to hold assets on behalf of your child to eventually hand them over in times of need. Alternatively, you can choose structured/custodial accounts, like UTMAs (Uniform Transfer to Minors Act) or UGMAs (Uniform Gift to Minors Act), where you transfer assets in your child’s account and invest on their behalf until they reach the legal age of trust termination. The trust termination age varies by each state and is generally between 18 and 21 years. Two key advantages of using trusts are:
- No restriction in the usage of money
- Lower burden of the estate tax for the donor
However, be careful when choosing a trust because the flexibility of usage of money could mean that the child does not use the money for education and splurges it on other purposes. Moreover, you cannot change the beneficiary later in life.
To sum it up
Each savings option has its pros and cons. So, you must carefully choose a medium that best matches your financial ability and requirements. In case you require help, you can always consult professional financial advisors to help you make the best choice.