A college education is expensive. Most families have to encourage their children to borrow in order to afford a higher education. There’s a reason that outstanding student loan debt in the United States tops $1 trillion.
If you want to reduce the amount of money your children have to borrow for college, you can start early to save up. Investing provides you with a way to boost returns over time. A few years ago, my husband and I opened a 529 plan with our son as the beneficiary. Every month, we automatically contribute to the account. Over time, our contributions to the account have grown significantly — and there are still six more years left for the account to grow.
The early you start invest for your child’s college, the better off he or she will be. Here are 3 tax-advantaged ways you can invest in your child’s college education:
1. 529 Plan
“The 529 is the most popular college savings program today, and has the greatest tax advantages,” says Gerry Frignon, the President and CIO of Taylor Frignon Capital Management.
What makes the 529 so attractive is the fact that the money in the account grows tax-free as long as the beneficiary uses the money for college. Many states also add a tax deduction for your contributions. So, while there is no federal tax deduction for 529 contributions, depending on the state you’re in, you might receive a break on your state tax bill.
However, Frignon warns, there are some drawbacks to the 529 plan. “It is irrevocable, expensive to operate, and inflexible in investment options,” he says. He also points out that there is a hefty 10 percent tax penalty if the money isn’t used for qualified education expenses.
It is possible to designate a new beneficiary, as long as the new student is related, if your child decides not to go to college. Before investing in a 529 plan, double-check expenses and investment options. For many families, a 529 can still be a good choice, since there are lower-cost possibilities, and index funds that provide you with instant diversity.
2. Coverdell Education Savings Accounts
With a Coverdell account, earnings grow tax-free, but there is no tax advantage for contributing, even at the state level. There are a number of investment options available for those wishing to use a Coverdell account. The choices are more varied than what is often available in 529 plans. Contributions to the account must be in cash, rather than in other assets.
The contribution limit to a Coverdell is much lower than what is available for a 529. In the case of a 529, it’s possible to contribute up to the amount necessary to provide qualified education expenses, up to the amount of the gift tax exclusion, each year. A Coverdell, on the other hand, has a contribution limit of $2,000 as of 2014. Additionally, there are penalties if the beneficiary of the Coverdell hasn’t used all the money in the account by the time he or she is 30.
3. Roth IRA
“Roth IRAs can be used for college savings,” says Frignon. This is a fact that surprises many people. Frignon likes Roth accounts as college savings vehicles because they are much more flexible when it comes to the types of assets that can be invested in.
However, when it comes to using Roth IRAs for college, Frignon has an interesting approach. “We would prefer the parent maintain control of the assets for any purpose and then ‘use’ those assets by prudently borrowing them in order to pay for college.”
Roth IRAs grow tax-free, and there is no deduction for contributions. One of the great things about the Roth IRA, according to Frignon, is that it is an account that can be kept for life, and there aren’t restrictions on how the money can be used (although you do have to watch out for penalties for early withdrawal when it isn’t for an approved purpose).
Carefully consider your situation and your goals as you start saving for your child’s college, and consider consulting a financial planning expert. And, even if you don’t have kids right now, it’s never too early to begin saving, says Frignon: “It is our view that parents outght ro begin saving before children arrive.”
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