The average all-in cost — tuition and fees — to attend a private, four-year college in the 2018-19 academic year was $35,830, according to Business Insider. That’s enough money to make any parent anxious. Families with more than one child have to worry about the compounding cost of their children’s education. The point? All the more reason to start saving early and use any tax-smart options at your disposal as soon as possible.
Luckily, there are several options. By using the right federal income tax breaks, parents can help put their children on the right foot forward for their future.
In this guide, we’ll look at 6 college savings strategies and the pros and cons of each so that parents can make the best plan possible.
Coverdell Education Savings Account
Also known as the Education IRA, the Coverdell Education Savings Account (CESA) is similar to a 529 Plan, a college savings plan that offers tax and financial aid benefits that we’ll review next. And that’s a great thing because it offers users tax-free investment growth and tax-free withdrawals provided all of the funds are spent on qualified education expenses.
With a CESA you can contribute up to $2,000 a year for every child you create an account for.
Now, you can’t deduct those contributions, but the money gets to accrue free of federal income tax. And when you’re ready to withdraw the funds for things like tuition, books, etc., it’s tax-free.
The only hiccup to CESAs is if your income is too high: $95,000 for single taxpayers and $190,000 for married taxpayers, according to the IRS. In that case, you can have a relative, say a grandparent, contribute.
529 College Savings Plan
State-sponsored college savings plans are a great tax-advantage opportunity. Essentially a parent contributes to a trust fund of their choice for their child’s education. These payments can be made in a variety of ways, via installments or lump-sums. And when it’s time to send junior off to school (be it in the state or out), a parent gets to enjoy the fruits of their labors by withdrawing the money federal income tax-free.
Taxable Investment Account
Another option is to use a traditional brokerage account to save for your child’s college tuition. While this doesn’t offer special tax privileges, it does give you the freedom to:
- Contribute as much as you want
- Invest in whatever you want
- Invest as much as you want
A brokerage account offers you more flexibility without tax breaks.
Traditional and Roth IRA
Using tax-advantaged savings account like a Roth IRA is a viable option for college savings thanks to a rule that allows you to withdraw money from your traditional or Roth IRA before reaching age 59½ without paying the 10% additional tax if it is to pay for qualified higher education expenses for your children or grandchildren. You won’t have to pay the usual 10% penalty, however, but you will still pay income tax on the earnings portion.
Yes, you’ll lose money from your retirement account, but on the flip side, you’ll help your child go to college.
Custodial accounts, also known as UGMA or UTMA accounts after the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act that created them, are created for your child and managed by you until they hit the age of 18 to 21, depending on your state. Once a child is of age, they take over the management of the account and can use the money however they want. There are no limits on contributions but parents can cap individual annual contributions at $15,000 per individual ($30,000 per married couple) to avoid triggering the gift tax, otherwise known as a taxable gift.
As of 2019, the Internal Revenue Service maintains the annual exclusion as remaining $15,000 in cash that can be given to other people. This goes up to $30,000 for spouses who combine their annual exclusions, tax-free. What does that mean? As a parent, you can give your child up to the annual exclusion each year to help pay for college.
But don’t forget to consider the lifetime exemption — the max amount you can give over your lifetime. So keep that in mind because gifts that go above the annual exclusion count against the lifetime exemption, which is $11.58 million per individual in 2020.
The bottom line is that college is expensive and that’s not about to change anytime soon. When it comes to saving, the time to hesitate has passed. If you want to be prepared to help your children pay for their higher education, you have to start making a plan now. But while you’re in the thick of putting money aside, take every tax advantage you can in the process. And if you can’t figure out the right plan for you, reach out to a tax expert who can help.