Education Planning Tips for Self-Employed Parents
Self-employment can be rewarding. You are your boss. You make your rules. You earn more, enjoy greater flexibility, and your work satisfaction level is high. And while all this can sometimes come at the cost of long hours, stress, and years of struggle, in most cases, the benefits of self-employment outweigh the cons. In the U.S., there are an estimated 16 to 25.5 million self-employed individuals. One possible disturbing factor about self-employment is the irregularity in income. As a self-employed person, there are high chances that your income varies from year to year. If last year was unusually good, the coming year might not be as profitable or could be even better than the previous one. Nothing is certain. While tactics like budgeting and keeping reserves can help minimize the impact of uncertainty, these strategies still cannot always sufficiently support the education expenses of your child.
Hence, as self-employed parents, it is advisable to plan the education expenses of your child and create a plan for their future well-in-time. Moreover, the rising education costs in the country have further aggravated the need for education planning. College tuition fees have skyrocketed in the last 30 years. The average cost of a four-year public institution has shot up by 213% over the last three decades. In the past decade alone, the cost of public college tuition has increased by 29%. The cost of private college tuition has risen by 25%. With such numbers, it is likely for parents to be worried about the future of their children.
Here are some tips that self-employed parents can use to plan for their child’s education:
- Invest in different 529 college plans to save for your child’s education costs: The 529 college savings plans are one of the most effective ways to save for your child’s future. If you begin investing in these plans at the right time, you can easily cover the education expenses of your child. 529 college plans are state-sponsored, tax-advantaged policies that allow you to invest your after-tax dollarsto adequately cover the cost of higher education. The money you save in these accounts is further invested in different secure bonds and low-cost stocks, generating competitive returns in the long-run. Moreover, the growth in this account is tax-deferred. And, you can take tax-free withdrawals from your 529 plan if the funds are used for a qualified purpose. As per the IRS (Internal Revenue Service), qualified education expenses include tuition, boarding, and books. In some special cases, such as scholarships, the IRS permits funds to be used for other purposes too. However, in general, when the funds are used for a non-qualified purpose, you have to pay federal income tax along with a 10% penalty on the earnings. Further, it is important to note that these plans offer significantly higher returns. Apart from the triple tax advantage, these plans also allow you to change your beneficiary in the future. This will be helpful in a situation where your first nominee does not require the funds, has received a scholarship, or has quit studying. In such cases, you can flexibly alter the beneficiary to name another child.
529 plans vary by each state, and the limit is usually between $235,000 and $529,000. As self-employed parents, this works well in your favor as your income is uncertain, and you can choose to contribute as per your financial capability each year. You can even convert your 529 college plan into a certified ABLE account. This allows you to support the non-qualified expenses of disabled kids and young adults.
Alternatively, a type of 529 plan called the 529 prepaid tuition plan can also work well for self-employed parents. These plans primarily sponsor your child’s tuition fees, which per experts are expected to rise by 5% each year. Hence, with a prepaid 529 tuition plan, you can pay all or a part of your child’s education cost in advance. The advance fee can be determined according to the aspired university or institution. As self-employed parents, you benefit from this provision as you cannot predict the exact inflow of cash. So, it is best to make the investments now when you have a sufficient balance. It further helps you evade the impact of inflation on the future tuition cost. The 529 prepaid plans mimic a 529 college plan and offer the same tax benefits. However, if your child quits studying or secures a full scholarship, the prepaid plan is disqualified unless you name another beneficiary or withdraw the money after paying a 10% penalty.
- Choose a Coverdell education savings account (ESA) for a broader choice of qualified expenses to cover your child education costs: The 529 plans alone can sometimes be inadequate to sponsor your child’s education. In this case, you can use other sound investments like a Coverdell education savings plan. You can choose to contribute to this account if your child is under the age of 18. This account works like a tax-deferred trust. You make after-tax contributions, your funds grow tax-deferred, and your distributions are also tax-free, provided they are used for qualified education expenses. As per the Coverdell plan, qualified education costs cover primary and secondary school tuition, uniforms, tutoring, and other K-12 expenses. The scope of qualified education expenses is broader in these plans in comparison to the 529 college plans. You can easily use your Coverdell account balance to finance the elementary and secondary education costs of your child. Further, this plan gives you a broader choice of investments in comparison to a 529 plan. However, you would be restricted by an upper contribution limit of $2,000. But as a self-employed parent, this does not prove to be disadvantageous if you use the Coverdell education savings account as a secondary funding option. Moreover, in case your child does not go to college in the future, you have the option to transfer the funds to another child or a relative.
- Use a Roth IRA to plan your child’s education expenses: A Roth IRA (Individual Retirement Account) is also a great medium to plan for your child’s education expenses. Roth IRAs allow you to invest after-tax dollars, earn tax-free returns, and take tax-free withdrawals. Due to the triple tax advantages, Roth IRAs have become an ideal choice to fund retirement years as well as your child’s education outlays. As a self-employed parent, if you can, you should consider opening a Roth IRA account in addition to the 529 savings plan and the Coverdell account. This is because a Roth IRA offers you more flexibility, significant returns, and greater tax benefits. Besides, in comparison to the above-mentioned plans, a Roth IRA gives you more freedom in terms of using your distributions. You can use your Roth IRA savings as you deem fit, unlike the Coverdell or the 529 college savings plans. Also, the investment basket in a Roth IRA is much wider, providing an opportunity to garner even higher returns. However, a Roth IRA comes with an upper contribution limitation. For 2021, you can deposit $6,000 annually. If you are above the age of 50, you can contribute an additional sum of up to $7000 annually. For contributions made beyond this limit, the IRS levies a 6% penalty every year until the error is solved.
- Invest in a sound life insurance policy to help fund your child’s future education expenses: For self-employed parents, life insurance policies can deliver two benefits. One, you get a secure life insurance cover. Second, you can accumulate a corpus for your child’s future education. In a cash-value-based life insurance policy, a part of the premium you pay is used to secure your life, whereas the other part of the premium is diverted to a separate cash-value account. The funds in this account grow at a predetermined rate, which is usually between 3% and 6%. Generally, whole life insurance plans are ideal in such scenarios. In these plans, the insurance company credits your account with a defined sum at a pre-agreed frequency. Further, the funds grow tax-deferred like a 529 college savings plan. However, if you are more of a risk-taker, you can opt for variable life insurance. This particular policy will invest a part of the premiums you pay in different market-linked securities. You can choose and govern your investments. But, the returns of your account are based on the performance of the underlying investment choices. You could generate greater returns, but you will also be undertaking a significant risk in this case. Alternatively, as self-employed parents, you can use your life insurance policy as collateral to procure a loan against it. The amount of loan can be used to pay for your kid’s education expenses. But the loan amount you take will be reduced from the insurance plan’s maturity or death benefits if you fail to pay back the loan in time.
- Take a Federal Parent PLUS or private loan to fund your child’s education expenses: If all other options above fail to meet your requirements, you can use the PLUS loans. As per a recent study from , approximately 3.6 million parents took out $96 billion in outstanding loans under the federal Parent PLUS program. PLUS loans let you borrow a sum equivalent to the college tuition fee by using the Free Application for Federal Student Aid (FAFSA). Further, to reduce your financial stress, the federal government offers several relaxations, enabling you to pay back the PLUS loans more conveniently. But, if you fail to get a PLUS loan, you can always consider taking a private loan at a lower interest rate from a bank or private lender. Private student loan rates may levy lower interest rates than federal loans, provided your credit score is 670 or higher. Besides, interest on student loans taken for college tuition or vocational school is also tax-deductible. For qualified students, the deductible limit is $2,500. However, individuals with an income of $70,000 or higher are not eligible for this exemption. In the case of married couples, the exemption limit is up to a total income of $140,000.
- Set up an educational trust to fund your child’s education costs in the future: As a self-employed parent, you might own a few assets that could help preserve the financial future of your children. You can place your listed assets in an educational trust and use them to fund your child’s education cost in the future. The trust will hold the assets on behalf of the child for a particular period. You can use the assets and later transfer them to the child once the tenure is over. In other cases, if your child is a minor, you can choose to invest in structured/custodial accounts like UTMAs (Uniform Transfer to Minors Act) or UGMAs (Uniform Gift to Minors Act). These accounts allow you to direct specific assets in your child’s account and invest them further for higher returns until your child reaches the legal age of trust termination. The legal age of trust termination varies as per the state in which the trust was established. In most cases, the legal age is between 18 and 21 years. A major reason why a trust works best for self-employed parents is that there is no restriction on how to use the money. Moreover, there is no penalty on withdrawals. So, if in the future, your child does not plan to take up higher studies, you can use the trust assets to sustain your retirement expenses or even leave the trust as a legacy for your children. Further, setting up a trust helps you lower your estate tax burden. However, the primary beneficiary of the trust cannot be changed later in life.
To sum it up
Apart from using these investment tools to plan for your child’s education, self-employed parents can also take advantage of several tax benefits offered by the government for education expenses. One such assistance is the lifetime learning credit (LLC) that is available for tuition and similar incidentals from undergraduate, graduate, and professional degree courses. However, you may want to consult a professional financial advisor to precisely understand which saving option works best for your financial situation and how you can maximize its potential to create a better future for your child.