Before opening the doors of Flow Financial Planning, I asked a lot of working mothers about their top financial concerns. One of the most frequent responses? “College planning!” (Yes, with the exclamation mark.)
I like to think of college planning in two phases: when your child is young, and when she’s approaching college age. Phase 1 focuses on saving money. It can be complicated, but it doesn’t have nearly as many moving parts as Phase 2, as your child gets close to college and many things start happening simultaneously: increased focus on high school grades, applying to and choosing schools, preparing and applying for financial aid, applying for scholarships, and so on.
This is the first of several posts about college planning, and this post focuses on the savings vehicle you choose for your child’s college savings. Future posts will talk about how to choose a specific 529 plan, how much to save, and what you can do to lower the cost of college when the time comes.
Choosing a Vehicle for Your College Savings
Most of us talk exclusively about 529s when we talk about college savings. But there are other savings vehicles worth considering. Below I list the most common types of savings vehicles for college savings along with the pros and cons I consider most important.
529
Pros:
- Effectively unlimited contribution
- Some states offer state tax deductions on contributions
- Funds can be used for the beneficiary’s entire life
- Funds grow tax-free and are tax-free when withdrawn if used for “qualified” expenses
Cons:
- Investments restricted by plan (Only a problem if the investments aren’t good!)
- Funds must be used for qualified education expenses (but that’s the whole point, right?); if not, can incur taxes and penalties
Coverdell ESA
Pros:
- Can be used for K-12 expenses, too
- Broad range of investment options
- Funds grow tax-free and are tax-free when withdrawn if used for “qualified” expenses
Cons:
- Cannot change beneficiaries
- Cannot contribute if your joint income tops $220,0000
- $2000 maximum annual contribution per child
- Contributions must stop by age 18 and funds be used by age 30
- No possibility for state tax deduction
- Funds must be used for qualified education expenses; if not, can incur taxes and penalties
Taxable Account in Parent’s Name
Pros:
- Unlimited contributions
- Broad range of investment options
- No restrictions on use of money
- No restrictions on access to money
Cons:
- Fewer tax benefits (you can still invest tax efficiently).
- Easy to confuse these savings with rest of savings for other goals.
Parent’s Roth IRA
Pros:
- No restrictions on use of money
- Broad range of investment options
- Your contributions can be withdrawn tax-free and penalty-free
Cons:
- Easy to confuse these savings with retirement savings and jeopardize retirement
- High-income earners aren’t eligible for contributions
UGMA/UTMA (Uniform Gift/Transfer to Minors Act)
Pros:
- Unlimited contributions
- No restrictions on use of money
- Broad range of investment options
- Preferential tax rate on first $2000 of investment earnings (“kiddie tax”)
Cons:
- The money in the accounts become irrevocably your child’s at some point in their early adulthood (age 18 or 21). You no longer have control.
- No tax benefits for using funds for higher education.
- Hurts your chances of financial more than other savings plans because assets belong to the child, not the parent
My Usual Recommendation
I often recommend a combination of a 529 and a taxable account (a separate taxable account dedicated solely to college savings) because it provides a comfortable balance of flexibility, tax benefits, and clearly designated (“targeted”) savings. In later posts, I’ll discuss my recommendations for how to balance savings between these two.
Who Should Own the 529?
Ownership of these accounts can ultimately have a large effect on your child qualifying for financial aid. We’ll discuss this more in future blog posts, but I generally recommend that parents own the 529. Under 6% of a parent-owned 529 will be included in the family’s expected contribution (federal financial aid calculation). If a child owns the 529, the expected contribution is much higher. A grandparent-owned 529 will end up creating significant income for the family, and that is heavily counted in the calculation.
When should you use a Coverdell ESA?
529 plans used to be, on average, much more expensive than they needed to be. At that point Coverdell ESAs were more attractive comparatively. But the investment world has relentlessly driven down costs in almost every sector, and now many states offer low-cost, simple plans, and with fewer restrictions on the use of the money than Coverdell ESAs.
Coverdell ESAs can still be a good choice if you want to save for K-12 costs. I recommend having a separate account for K-12 and college costs to keep your goals and timelines clearly delineated.
When should you use a parent’s Roth IRA?
I prefer saving for goals in very clearly defined buckets. It makes planning your savings much more straightforward, you can easily see progress (or lack thereof) towards each specific goal, and it’s a lot harder to unwittingly spend money set aside for Goal A (say, retirement) on Goal B (college) instead. That said, if by the time your child gets close to college, your retirement savings are well on track, then at that point I think you can consider using Roth IRA funds.
Using traditional IRAs and employer retirement plans is much more complex and should be closer to the “last resort” end of the spectrum.
When should you use a UGMA/UTMA?
I generally don’t think UGMAs/UTMAs are a good choice for college savings anymore. I consider them a holdover from the time prior to 1996, the year 529s were introduced. If you want flexibility, use your taxable account. If you want preferential tax treatment, use a 529 or Coverdell ESA. There might be other reasons to use a UGMA/UTMA, but college savings isn’t one of them.
References
http://www.savingforcollege.com/
https://www.irs.gov/pub/irs-pdf/p970.pdf
Read the next post in this series.
If you are interested in learning about how I can help you prepare for your child’s college education, please contact me at or schedule a free 30-minute consultation.
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