Sending your children to college is expensive. According to the College Board, the average cost of one year of college in 2017 at a two-year community college was $7,560, $14,210 for in-state public colleges, and $26,100 for private non-profit colleges.
And, to make matters worse, the College Boards’ calculations are AFTER financial aid. These were the out of pocket costs to parents and students for one year of tuition, room, board, and books.
The cost of a college education continues to rise each year too. In fact, the rising cost of college is outpacing inflation and is growing faster than most other purchases we make. The rising cost of college is double the standard inflation rate.
So, what can you do about the rising cost of college? How do you plan to pay for college? A 529 College Savings Plan can be a great investment to help you and your family plan ahead for the day your kids go off to school. These plans also have a few unique benefits that make them a great way to save for college.
How 529 College Savings Plans Work
Congress created 529 College Savings Plans in 1996, and they are very similar to Roth IRAs. Like a Roth IRA, parents can invest in mutual funds with after-tax dollars. Then, parents and students can use earnings from the investment tax-free as long as they use them for qualified education expenses such as tuition, room, board, fees, books, and the like. If you use the money for something other than education, you have to pay penalties and taxes on the earnings from the investment.
Typically, each state has it’s own 529 College Savings Plan that they, or investment companies on the state’s behalf, administer for investors. Parents are free to choose the 529 College Savings Plan of any state, but you often receive a tax deduction on state taxes if you choose the plan in the state where you reside. So, a 529 College Savings Plan can also help you save on your state income taxes as well.
Each state typically offers several options for parents to invest – usually in four or five mutual funds. These funds are based on an investor’s risk tolerance and many states balance the funds available or rebalance the holdings based on the child’s expected freshman year of college.
For example, I invest in the Georgia 529 College Savings Plan, which the state calls the Path2College 529 Plan, for my children. Every state seems to have unique names for their plans to help them with marketing. The Georgia plan offers several investing options that range from TIAA-CREF nine managed exchange traded funds (ETFs) that mirror boarder stock market and bond indices to a real estate investment trust (REIT and emerging market fund. The investment choices really run a wide gamut of options.
As you get closer to sending your kids off to school, the risk profile of the holdings become more conservative to preserve capital and hedge against market volatility as you get ready to use the money for college expenses.
Another great benefit of 529 plans is that you can transfer them to other siblings. If you’re lucky enough to have a child that earns a lot of scholarships, you can move his or her 529 plan balance to another family member.
Alternatives to 529 College Savings Plans
There are several options for parents if you didn’t want to invest in a 529 College Savings Plan. Below are four of the most popular alternatives that you may want to consider.
- Coverdell Education Savings Accounts
- UGMA/UTMA Accounts
- Prepaid Tuition Plans
- Prepaid Tuition Plans
Coverdell Education Savings Accounts
A Coverdell Education Savings Account (ESA) allows parents to invest in almost any type of security – stocks, bonds, mutual funds, etc. With a Coverdell ESA, the plans do not lock parents into the limited investment choices of a 529 plan. Like 529 plans, a Coverdell ESA allows parents to invest with after-tax dollars and withdrawal earnings tax-free for educational expenses. You can also use an ESA for private elementary and secondary school as well as college costs.
One drawback of a Coverdell ESA is its low contribution limits. Parents can only invest $2,000 each year in a Coverdell ESA. There is also a mandatory withdrawal at the age of 30 unless you transfer the benefits to another family member.
The Uniform Gift to Minors Account (UGMA) and Uniform Transfer to Minors Account (UTMA) are accounts set up by the parent, but they are ultimately an asset of the child. Unlike a 529 College Savings Plan, parents have wide latitude on what they can invest in. You have almost unlimited investment choices with UGMA/UTMA accounts, but these accounts do not have the same tax benefits as a 529 plan.
The federal government taxes UGMA/UTMA accounts at the child’s tax rate when withdrawn. And, the child does not have to specifically use the account for college despite that being the initial intent. Because UGMA/UTMA accounts are considered assets, they could also impact the amount of need-based financial aid colleges award. 529 College Savings Plan balances are exempted from the calculations.
Prepaid Tuition Plans
I went to a small liberal arts private college in South Carolina. For the longest time, I invested for my children in the Private College 529 Plan, which is a prepaid tuition plan that caters solely to private colleges in the United States.
With prepaid 529 plans, you purchase credits or semesters at today’s prices. You are literally prepaying tuition for your child’s college. If you use prepaid 529 plans, you are betting that the cost of college will be higher when you children finally attend.
One issue for prepaid 529 plans is that the plans often lock you into using the credits that you’ve prepurchased only at participating colleges. But, if you change your mind down the road, you can transfer your account balance to a more traditional 529 College Savings Plan sponsored by a state if you choose.
Finally, you are always free to invest for your children’s college education in taxable accounts. With taxable accounts, the parents hold the investment in their names, and the parents are free to disperse the funds as they see fit for any expense.
There are tax benefits or penalties associated with taxable accounts. But, colleges will use the account balances against you when calculating need-based financial aid.
529 College Savings Plans can be a great way for parents to save for college education. There are many tax benefits associated with a 529 plan from reduced state income tax to tax-free withdrawals. 529 College Savings Plans allow parents to invest the funds in several different mutual funds with diversity and grow tax-free.
But, there are other options out there if parents want to go a different route to save for college. It’s important to understand the choices and make the best one for your family and situation.