The average cost of college can be as much as
Several college savings plan options are available. Each offers certain advantages as well as potential tax and financial aid implications. From individual retirement accounts (IRAs) to an education savings account, here's what you need to know about different college savings vehicles.
529 college savings plans
A 529 plan allows you to save for college expenses. The money grows tax-free, and you can withdraw it tax-free to pay for qualified education expenses. It is important to know that the earnings on investments in 529 plans are not guaranteed and can lose value based on market conditions.
These plans are typically administered at the state level, have high contribution limits and may offer a tax deduction, depending on the state. For example, in Massachusetts, you can receive a state tax deduction on up to $2,000 of your contributions to a 529. Massachusetts also has a contribution limit of $500,000.
One of the advantages of a 529 plan is the benefit of tax-free withdrawals if you use the money to cover specific education costs. You can also transfer a 529 plan to eligible family member. Hypothetically, let's say your first child gets a full scholarship to college but you have money sitting in a 529 plan. You can change the beneficiary to your younger child and use the money to pay for that child's college. You could also put the account in your own name or transfer it to another eligible relative.
An important consideration when funding a 529 plan is that it can affect your child's financial aid, especially if the account is in their name. 529s also have limited flexibility. Remember to take into account the possibility of your child getting a full scholarship or having a family member contribute to their higher education costs. Depending on state requirements, you may not be able to use this money for non-education purposes. However, they may still be used to pay for housing expenses. When you use these funds for non-educational costs, there is typically a 10% penalty and income taxes on the earnings within these withdrawals. (This penalty is waived in the event of a death or disability.) If you want more flexibility in paying for college, a brokerage or custodial account may give you more options.
Coverdell education savings account
Like a 529 plan, a
However, one of the biggest differences between a 529 plan and Coverdell is that a Coverdell account has lower contribution limits, and your family must be below a certain income threshold to be eligible to contribute to a Coverdell. Currently, the
If you are eligible for a Coverdell, it's important to know that, similar to many of the other college savings plan options, this account will impact financial aid. Also, you can't hold onto this account forever—any amount remaining in the account must be distributed to a beneficiary within 30 days of their 30th birthday, unless the recipient is considered a special needs beneficiary. The beneficiary then can choose to transfer this account to another family member to avoid potential taxes on earnings and a 10% penalty.
Roth and traditional IRAs
If you withdraw from an Traditional IRA before 59½, you'd have to pay a 10% penalty on your withdrawals along with income taxes. However, the IRS allows account holders to take distributions from a Roth or traditional
You can take a qualified education distribution from an IRA to pay education expenses for you, your spouse, children or grandchildren. Qualified education expenses include tuition, fees, books, supplies and equipment necessary for attendance at any college, university, vocational school or other postsecondary educational institution eligible to participate in the U.S. Department of Education's student aid programs.
Using money from an IRA to pay for college has certain advantages and disadvantages. The main advantage is the penalty-free withdrawals for qualified education expenses, which can give your family additional financial flexibility if the student doesn't receive enough financial aid or scholarships to pay for college. This also may help your student avoid loans and debt after they graduate.
However, there are downsides to using an IRA to cover college costs. For one, the withdrawal will reduce your savings earmarked for retirement and you'll potentially miss out on the tax-free or tax-deferred growth on the amount you withdraw. You'll likely also pay income taxes on any earnings you withdraw, and you have to make sure you fully understand what specific education expenses qualify or you could face the 10% penalty. Another issue is that your withdrawals, even if qualified, may count as income if your family files the
Keep all these factors in mind before choosing to use your IRA to pay for college, especially if there are other college savings plan options that may offer more flexibility.
General investment accounts
A general investment account, or a brokerage account, is among one of many college savings plan options.
With this account, you have more freedom to choose how you invest—whether it's in a mutual fund, index fund or individual stocks and bonds. Unlike retirement accounts, there is no cap on how much you can contribute every year, and you have more flexibility to withdraw whenever you want and for whatever purpose you choose, including paying for college.
However, there are tax implications depending on how long you've held assets in the account. You may have to
Using a general investment account to pay for college expenses comes with its own pros and cons. Similar to an IRA, you'll potentially sacrifice tax-deferred growth on the amount you withdraw. Another consideration is that the amount you withdraw will count as income and factor into your expected family contribution and financial aid package. Currently,
However, the upside of using a general investment account is that you don't have to worry about qualified education expenses. If you want to use the money to buy the student a car to get around campus or to or from their internship, you can do that. It doesn't just have to be to pay for tuition, fees or books.
There are two main types of custodial accounts: a Uniform Gift to Minors Act (UGMA) account and a Uniform Transfer to Minors Act (UTMA) account.
The main difference between
Each account has one designated custodian (typically a parent) and one designated minor beneficiary. However, the major drawback of custodial accounts is that the assets in these accounts are irrevocable, meaning the contributions made to the account belong to the beneficiary. You can't take them back or make withdrawals.
Some of the biggest benefits of using an UTMA or UGMA to pay for college is that there's no limit on the amount you can contribute or no income eligibility limit. These accounts also get favorable tax treatment, since the deposits are considered gifts and therefore tax-free under the annual gift exclusion. Beneficiaries who are under 19 years old, or under 24 and a full-time student, and whose taxable income is below $1,150 aren't subject to taxes. After that, the next $1,150 in unearned income is taxed at the child's income tax rate (any income in the account over $2,300 is taxed at the custodian's federal income tax rate). You also can use this account for any purpose—not just to pay for college—so it's much more flexible than an IRA, 529 or Coverdell college savings account.
However, custodial accounts also can affect financial aid. Currently, up to 20% of a child's assets count toward the
Permanent life insurance and trusts
Permanent life insurance features what's known as
With a trust, you can structure it any way you choose, including requiring that distributions only be used for education. A trust allows you to have more control over assets contained within the trust, how they are invested and how they are distributed. You can establish qualified transfers that generally do not affect beneficiaries' annual or lifetime exclusion, which is the maximum amount you can transfer to someone else as a gift. Depending on how much you gift a child or family member, how you structure the trust, and the beneficiary's access to the trust, it may affect financial aid in varying ways. For example, the value of the trust may restrict the child's eligibility for need-based financial aid altogether.
Getting a head start on saving for college
Whether you choose to use an IRA, 529 plan, general investment account or permanent life insurance to save for college will depend on your savings goals and the level of financial flexibility your family requires. A
Contribution limits, tax consequences and rules around qualified distributions vary by each account. If you decide to use an IRA or general investment account as a college savings vehicle, you also have to weigh how this will affect future retirement savings. We all want to give students every opportunity possible. These college savings plan options allow you to start early, gradually build your family's savings to