The Best Approach to Plan for Your Child’s College Education
The cost of education in the U.S. has increased more than three times over the last three decades. This is creating a financial burden on students and their parents. Moreover, it is forcing them to focus more on finding educational loans instead of a suitable college. According to a 2020 report by EducationData.org, the average college fee in the U.S is $32,889 per student. With such high costs, parents need to find the right approach to plan and save for their child’s education. That said, even though saving for a child’s education is the main goal, most parents either start too late or do not have sufficient funds to support the high costs. So, if you do not have any plan in place for your child’s future, you must start now.
Here are some of the best methods you can use to save for your kid’s education:
529 college plans
These state-sponsored, tax-advantaged plans are one of the best options to cover higher education costs. This college-savings plan invests your after-tax dollars into bonds and low-cost stocks for optimum diversification. Moreover, you can withdraw your savings without paying any taxes, provided they are used for eligible education-related expenses. Some eligible or qualified educational costs include tuition, room rent, boarding charges, and the cost of books. But in case you use your 529 plan savings for any other non-qualified expenditure, the IRS (Internal Revenue Service) charges income tax and a 10% penalty. However, the tax and penalty are charged only on the earnings and not on the contributions. That said, each U.S. state has different rules for a 529 college plan. Hence, it is best to understand each state’s plan in detail and then opt for the best state’s policy, depending on the benefits.
It helps to invest in a 529 as soon as possible because these plans offer considerably high returns, enabling you to comfortably fulfill the educational expenses of your child. As per the College Savings Plan Network, 529 plans rose to a record high of $352.4 billion in assets in the first half of 2019. Even though the COVID-19 situation had a huge impact on the 529 asset balance, bringing it down to $293 billion in March 2020, the plan is expected to regain momentum because of its significant advantages. Apart from the triple tax advantage offered by the 529 plan, you also enjoy flexibility in naming beneficiaries for this account. So, in case the existing beneficiary of your account does not need the funds for higher education, you can change the designated beneficiary in the future to cater to another child’s education. Further, the IRS levies no upper limits on the annual contribution to 529 plans. Each state has a different limit, usually between $235,000 and $529,000. Besides, you can rollover your 529 savings balance into a certified ABLE account to support the non-qualified expenses of disabled kids and young adults. That said, amidst these advantages, it is always advisable to be careful with the withdrawals from this account.
529 prepaid tuition plans
Another approach that can help you save well for your child’s education is a 529 prepaid tuition plan.As per reports, college tuition fees rise every year by almost 5%. These costs can be an extreme burden for parents. The 529 prepaid tuition plans allow you to pay a portion or all of your child’s education costs in advance. The cost you pay can be in line with a specific university or an “aspire to” group of institutions. The main benefit that these plans offer is the ability to pay for the costs of the future in the present, thus, allowing you to evade the sharp inflation in the tuition costs. Apart from offering you this benefit, 529 prepaid tuition plans allow your savings to grow tax-free. Moreover, these accounts have no income or age restriction limits and each state offers different but usually very high contribution rates. Similar to a traditional 529 savings plan, prepaid plans also allow you to change your beneficiary, if need be, in the future. However, since 529 prepaid plans are precisely designed to cover educational expenses, they can be disqualified if your child does not study further or if they get a full scholarship. But you can avoid this by either changing the beneficiary or paying a 10% penalty to withdraw the funds.
Coverdell education savings account
A Coverdell education savings plan is also a great medium to save money for your child’s education. The Coverdell plan is like a tax-deferred trust, where you can contribute your after-tax money to save for your child’s college, elementary, as well as secondary education costs. This plan allows your funds to grow tax-free and exempts you from any tax charge at the time of withdrawals. However, the distributions from the Coverdell savings account can only be used to fund qualified educational costs. The definition of a qualified education cost in this plan is broader than a traditional 529 college savings plan. Under the Coverdell education savings account, withdrawals taken for primary and secondary school tuition, uniforms, tutors, and other K-12 costs are not levied any tax penalty. In addition to these benefits, the account offers you a wide variety of investments to choose from, unlike a 529 savings plan. But you can only save up to $2,000 annually in this account until the beneficiary is 18 years old.
Apart from being one of the most popular and coveted retirement savings accounts, a Roth IRA (Individual Retirement Account) is also a useful tool for education savings. Roth IRA offers numerous benefits and flexibility. When you save funds in a Roth IRA, you only pay taxes on the money you deposit and no taxes on the withdrawals. Owing to this advantage, you can use your Roth IRA money for retirement, as well as to support your child’s future. The best part about this account is that because you invest your after-tax dollars, you can evade higher taxes later in life. Also, your after-tax contributions get a long period to ensure maximum growth potential since you cannot withdraw any savings before the age of 59.5. That said, unlike other educational plans like a 529, a 529 prepaid plan, or a Coverdell education savings account, a Roth IRA allows you increased flexibility when it comes to using the funds.
But before you invest in a Roth IRA, you should know the maximum contribution limits for each year. For 2020, the IRS has set a sum of $6,000 annually. However, if you are aged 50 or older, you can contribute $7,000 annually. If you invest more than the upper limit, you will pay a penalty of 6% every year until the error is revised.
To sum it up
In addition to these methods, you can also choose to build a trust for your child’s future, invest money into eligible savings bonds, put funds in a custodial account, invest in an Education Savings Account (ESA), etc. However, each of these options has its pros and cons, which you should study carefully. Pick an option that best matches your financial needs.
You can also consult professional financial advisors to help you make the best choice.