Being able to send your child to college is near the top of the wish list for most parents. A college education can open doors to many opportunities and is increasingly necessary in today’s economy.
But that diploma doesn’t come cheap!
Parents who are on solid financial footing should start saving for college as early as possible. Ideally, you’ll want to choose a college savings vehicle that offers the best combination of tax advantages, financial aid benefits, and flexibility, while meeting your overall investment needs.
How Will I Pay for College?
Year after year, thousands of students graduate from college. So how do they do it? Many parents save less than 100% of their child’s education costs before college. Typically, they put aside enough money to make a down payment on the college bill (in the same way you might purchase a home). Then, at college time, parents supplement this down payment with:
- Current income
- College loans
- Private loans (e.g., home equity loan, margin loan)
- Investments (e.g., 529 plan, mutual funds, 401(k) plan, cash value life insurance)
- Federal and college student-based financial aid (e.g., student loans, grants, scholarships, work-study)
- Child’s savings, investments, and/or earnings from a part-time job
- Gifts from grandparents
Start a Savings Program as Early as Possible
Perhaps the most difficult time to start a college savings program is when your child is young. New parents face many financial strains that often take over: the possible loss of an income if a parent stays home, child-related costs, large expenses for a house or car, or the demands of your own student loans. Yet, this is the time when you should start saving.
When your child is young, you have time to select more aggressive investments that have the potential to outpace college cost increases. You gain the ability to invest with a relatively long-term outlook and capture the benefits of compounded growth.
Compounded growth is achieved by earning additional investment growth on prior year investment gains. With regular investments spread over many years, you may be surprised at how much you can accumulate in your college fund. This table shows how a consistent monthly investment might grow over a certain period of years.
|Amount Invested||5 years||10 years||15 years|
Note: Table assumes an after-tax return of 6%. This is a hypothetical example and is not intended to reflect the actual performance of any investment.
The Best Ways to Save for College
Not all strategies are created equally when it comes to college savings. The best savings vehicles offer tax advantages if the funds are used to pay for college. Tax-advantaged strategies are important because over time, you can accumulate more money compared to a taxable investment.
Since their creation in 1996, 529 plans have become to college savings what 401(k) plans are to retirement savings. They are an indispensable tool for helping you amass money for your child’s or grandchild’s college education. That’s because 529 plans offer a unique combination of benefits unmatched in the college savings world.
There are two types of 529 plans – college savings plans and prepaid tuition plans.
529 College Savings Plans
A 529 college savings plan is a tax-advantaged college savings vehicle that lets you save money for education in an individual investment-type account.
529 college savings plans offer a unique combination of features that no other college savings vehicle can match:
- Federal tax advantages: Contributions to your account grow tax-deferred and earnings are completely tax-free if the money is used for qualified education expenses. If funds are withdrawn for non-qualified education expenses, the earnings portion is taxed and subject to a 10% federal penalty. However, there are four important exceptions:
- The beneficiary of the plan becomes disabled.
- The beneficiary receives a tax-free scholarship.
- The beneficiary receives educational assistance through a qualified employer program.
- The beneficiary attends a U.S. military academy.
- State tax advantages: Many states offer income tax incentives for state residents, such as a tax deduction for contributions or a tax exemption for qualified withdrawals. Many states require contributions to be made to state-approved plans to claim such tax benefits.
- High contribution limits: Most college savings plans have lifetime maximum contribution limits of $300,000.
- Unlimited participation: Anyone can open a 529 college savings plan account, regardless of income level.
- Flexibility: Under federal rules, you can change the beneficiary of your account to a qualified family member at any time without penalty.
- Wide use of funds: Money in a 529 college savings plan can be used at any college in the United States or abroad that’s accredited by the U.S. Department of Education and, depending on the individual plan, for graduate school.
- Variety: Currently, there are over 50 different college savings plans to choose from because many states offer more than one plan. Note: State tax requirements might limit plan choices to receive state tax benefits.
An added benefit of a 529 college savings plan is that it can be used for K-12 tuition costs up to $10,000 a year. This is an attractive savings feature for parents with children in private schools. And if there are funds remaining after graduation and the student has loans, up to $10,000 can be used toward paying loans.
While these plans offer many benefits, college savings plans have a drawback: returns aren’t guaranteed. Your investments can gain or lose value, depending on how the underlying investments perform. If investment risk is of concern, 529 prepaid tuition plans are worthy of consideration.
529 Prepaid Tuition Plans
Prepaid tuition plans are distant cousins to college savings plans–their federal tax treatment is the same, but their operation is very different. A 529 prepaid tuition plan is a tax-advantaged college savings vehicle that lets you pay tuition expenses at participating colleges at today’s prices for use in the future. Prepaid tuition plans can be run either by states or colleges.
As with 529 college savings plans, you’ll need to fill out an application and name a beneficiary. But instead of choosing an investment portfolio, you purchase an amount of tuition credits or units. Typically, the tuition credits or units are guaranteed to be worth a certain amount of tuition in the future. As such, prepaid tuition plans provide some measure of security over rising college prices.
- Federal and state tax advantages: The federal and state tax advantages given to prepaid tuition plans are the same as for college savings plans.
- Other similarities to college savings plans: Prepaid tuition plans are open to people of all income levels, and they offer flexibility in terms of changing the beneficiary or rolling over to another 529 plan once per year, as well as accelerated gifting.
Prepaid tuition plans have some limitations, though, compared to college savings plans. One major disadvantage is you’re generally limited to your own state’s prepaid tuition plan, and then you’re limited to the state colleges that participate in that plan. If your child attends a different college, prepaid plans differ on how much money you’ll get back. Also, some prepaid plans have been forced to reduce benefits after enrollment due to investment returns that have not kept pace with the plan’s offered benefits.
Even with these limitations, some college investors prefer trying to lock in today’s college tuition to the best of their ability.
The following table summarizes the main differences between 529 college savings plans and 529 prepaid tuition plans:
|College Savings Plans||Prepaid Tuition Plans|
|Offered by states.||Offered by states and private colleges.|
|You can join any state's plan.||State-run plans require you to be a state resident.|
|Contributions are invested in your individual account in the investment portfolios you have selected.||Contributions are pooled with the contributions of others and invested by the plan.|
|Returns are not guaranteed; your account may gain or lose value, depending on how the underlying investments perform.||Generally, a certain rate of return is guaranteed in the form of a percentage of tuition being covered in the future, no matter how much costs may increase by then.|
|Funds can generally be used for tuition, fees, room and board, equipment and books at any accredited college or graduate school in the US or abroad.||Funds can be used only at participating colleges (typically state colleges), and room and board and graduate school expenses generally are not eligible expenses.|
|Funds can be used for K-12 tuition, up to $10,000 per year.|
Qualified Education Expenses
To be tax-free at the federal level, investment funds have to be used for “qualified” education expenses.
Qualified education expenses for 529 college savings plans include tuition, fees, books, equipment, and room and board for college and graduate school. Conversely, prepaid tuition plans generally include just tuition and fees for college only (not graduate school) as qualified education expenses.
SageVest Wealth Management works with individuals and families to achieve a variety of goals, often including college funding for children and grandchildren. We strongly value the importance of education and enjoy helping future generations gain the opportunity to learn and succeed. Please contact us if you would like to discuss appropriate savings and funding vehicles for your children, grandchildren, or other family members.