When my daughter was born, my obsession with financial planning had a terrible collision with the reality of steep child rearing costs. So many financial questions ran through my mind:
- How high are my insurance premiums going to rise?
- How will we pay for her college education?
- How will having children change our food expenses in the future?
- Will she really go through 8-12 diapers a day? (Answer: Yes... *sigh*)
My MBA training slowly clicking into gear, I dove into a spreadsheet to run a bunch of calculations, based on various assumptions. I felt like Will Hunting solving an unsolvable math problem.
After some time, thought, and countless “It’ll all be fine”s from my wife, I started tweaking the budget, identifying ways to cut some expenses, and thinking through the positive financial impact of things like The Child Tax Credit and tax-advantaged investment accounts. I could breathe again.
The Challenge of Paying for College
When it comes to our children, there are a lot of financial matters to think about. Some, however, feel weightier than others. For many of us, one of the biggest issues is how to pay for our kids’ college.
College costs are getting absolutely crazy. According to The American College, over the past 10 years the costs of public universities has increased at an average rate of 5.6%. That’s over twice the consumer price inflation rate over the same decade. Here’s a chart from US News & World Report to illustrate the impact.
A side effect of this has been a sharp increase of outstanding student loan debt, which as of June 2015 was at $1.2 trillion.
Different Strokes for Different Folks
Saving for college also looks different for a lot of families. My parents helped very little when it came to my college expenses. Other parents understand the school their child chooses to attend may carry an unavoidably high price tag, such as an ivy league or private college.
Fortunately, if you plan to help your kids with at least some schooling costs, doing a little investment planning for your kids schooling is time and money well spent. Investing towards a particular goal like covering at least some college costs can also help you keep up with the increasing costs of attendance.
There are several options when it comes to saving for your children’s college.
The first option is a Section 529 savings account, more simply known as a 529 account. These are saving accounts specifically designed to help save for college expenses.
Let it Grow!
529 accounts are more than just savings accounts. They are investment accounts, too. This means contributed funds can be invested into different types of investments available in your 529 account. These investments grow tax-free. 529 accounts are run by individual states, so available investment options may vary, depending on how the state chooses to run their 529 program.
My daughter’s Utah-based 529 (UESP) account has model portfolios made up of a collection of different low-cost mutual funds. Model portfolios can be a nice approach, since the work of picking investments is already done for you. They are also self-adjusting, moving to less conservative investments as time goes along.
529 Tax Advantages
Money contributed to a 529 account has some great tax advantages. Contributions are made on an after-tax basis, however any earnings taken from the account are tax-free as long as they are used for qualified college expenses, like tuition or room and board. Your investments grow tax-free within your 529 account as well.
There are several other benefits to a 529 account. Contribution limits for 529s are quite high, usually around $14,000 if parents want to avoid the consequences of gift taxes.
They’re portable as well. Opening a 529 in most states doesn’t mean you can’t use the funds for a school in another state. Also, funds can be transferred to another person. So I could transfer the account to another child if my daughter ever dropped out of school and ran away with her high school boyfriend.
“But daddy I love him!”
- The Lovestruck Little Mermaid
529’s do have some drawbacks. Once the funds have gone into the account, they can be taken out for qualified expenses only, and may be penalized otherwise. 529 funds count towards student loan eligibility, meaning higher balances in a 529 account may mean your child can take out less in student loans.
Some states have caps on 529 account balances. These are quite high, typically ranging from about $250,000 to $400,000. The federal rule dictates that accounts cannot exceed the expected cost of the student's college expenses.
Coverdell Education Savings Accounts, sometimes known as education IRAs, are another college saving option.
Broader Investment Options
Coverdells have a broader selection of investments compared to 529s. Coverdell funds can be invested in stocks, bonds, ETFs and even alternative investments in some cases. Parents are allowed to contribute up to $2,000 annually per account, per beneficiary.
Greater Education Flexibility
Why the significant gap between the contribution limit of the 529 ($14,000) and the Coverdell ($2,000)? One reason is Coverdells can be used for more than just college expenses. Coverdell’s eligibility expands to elementary, secondary, and post-secondary education expenses. So for parents who have their eye on a K-12 private school for their children, a Coverdell could be advantageous.
Coverdell Tax Advantages
Tax benefits of the Coverdell are similar to 529s. Contributions are not deductible, but earnings are not taxed as long as they are used for eligible expenses. These accounts are geared towards middle-income families, so there is a phase out for joint filing families with an adjusted gross income of $190,000 to $220,000, as of 2016.
[529 v. Coverdell chart comparison]
Other College Saving Options
A traditional investment account probably offers the greatest flexibility for college savings, considering the combination of investment choices and contribution limits.
A normal brokerage account has no contribution limits and you’ll also have access to a nearly endless variety of stocks, bonds, ETFs, options, mutual funds, and other investments.
The downside is there are no tax advantages to these accounts. Capital gains and dividends will be subject to their fair share of taxes based on federal and state rates.
Your personal 401(k) account may be another savings option, with an interesting twist. Most 401(k)s have a feature that allows you to borrow funds from your 401(k). This is typically no more than half of your account balance, and must be paid back with interest over a specified period of time.
By borrowing funds from your 401(k) for your child’s college education, you essentially become your own lender, paying yourself interest as well.
There are a few things to be mindful of. If you ever leave your employer which provides the 401(k) then the loan needs to be paid back immediately. Also, any 401(k) dollars not in your account are losing the opportunity to work towards their primary purpose - funding your future retirement.
A trust is simply a legal agreement which allows a trustee (like you) to hold assets on behalf of a beneficiary (like your kids). Assets are often held in trust for a couple of reasons.
First, trusts can often avoid probate. This makes trust funds more accessible after someone passes away. Second, trusts can be designed with a high level of detail. You can specify who gets your assets, how much, when, and so on.
For example, you could design the trust to only be used for educational expenses from your alma mater (sorry son, no clown college for you).
Or you could require that funds taken from the trust need to be paid back with interest over a certain period of time. The options are limitless.
Trusts will bear some extra cost, as they are legal documents that should be set up by an attorney.
Whatever You Do...Get Saving!
Obviously there is a lot to think about when deciding which account to use.
If I could give one bit of advice, it would be to just get started saving. If you aren’t sure which type of account to open, save some money on the side while you talk with a financial advisor, a representative from a state-run 529 plan, or do your own research. Once you’ve made the decision, you’ll have a nice little chunk of money to start saving for your kids’ college.