As a parent, I can imagine the pride felt when a child graduates from college. Not only does the student work hard to graduate, but the parents also work hard both emotionally and financially to make it happen.
Due to the economy, a lot of students are taking on student debt to pay for their college education. One thing is certain – many parents want to help reduce this burden on their children, if possible.
Some options that parents are taking advantage of are scholarships, tuition plans or even refinancing their home. But, you can also potentially save for your child tax-free.
In this post, we’ll go over some common questions about three common college savings plans. Keep in mind that whenever you make a financial decision, it’s always wise to consult your financial advisor to help you find the best option for your unique situation.
What are UTMA/UGMA Custodial Accounts?
UTMA/UGMA accounts are great for parents or grandparents who aren’t concerned if the funds go to the child if the child doesn’t attend college. These accounts are basically savings accounts that the child can access once they turn 18. Before the child turns 18, the custodian of the account has access to the funds and can even use them, if necessary.
Factors to Consider
- Because these accounts are under the child’s social security number, parents or grandparents are not tax responsible for the gains that this account earns.
- Because of the “kiddie tax law,” some of the income generated by these types of accounts can go untaxed below $2,100, and any amount between $2,100 and $10,500 is taxed at the child’s tax bracket. Anything above these limits is taxed at the parents’ tax rate.
- There are many investment options allowed under these types of accounts, giving the owner flexibility. However, no high-risk investments are allowed.
- Since these types of college savings accounts are considered part of the child’s assets, when applying for financial aid, it could actually decrease the amount of financial aid the child can receive.
What Are Section 529 Savings Plans and How Do They Work?
529 college savings plans are investment accounts in which interest and investment earnings are untaxed. The plans are generally a collection of investments ranging from savings accounts to mutual funds, similar to a 401(k).
There’s a less common type in many states called a prepaid tuition plan where you buy tuition in advance at today’s prices to be used in the future. For instance, if you buy enough tuition credits to equal one semester, you can redeem those credits for a semester of tuition and fees when your child is ready to start college. Where the credits can be redeemed, and at what value, varies from plan to plan. Thus, you should always ask about exact rules.
Factors to Consider
- They’re great for families looking to save large amounts of money. While there are maximum amounts you can contribute, it’s generally enough to pay for one of the higher priced private universities. You can also have more than one investment account if needed.
- For most families, the bigger concern than maximum limits is choosing a plan with state tax deductions or depositing money that later isn’t used for Qualified Education Expenses:
- These are amounts paid for tuition, fees and other related expenses that are required for enrollment or attendance at an eligible educational institution for eligible students.
- Qualified expenses now includes a computer or laptop for college students.
- If you have to withdraw money for non-school reasons, you could incur a 10% federal tax penalty on the money withdrawn, in addition to income tax not paid on interest or earnings on the money withdrawn.
- You may also face a tax penalty from your state if you were given a state income tax deduction. While 529 plan contributions are made after federal taxes, you may not pay state income taxes on money you contribute. For instance, if your state offers a tax deduction on the first $10,000 your family contributes, you’ll get back the state income tax you paid on that amount.
When choosing a 529 plan, start by going to the College Saving Plans Network website and use the search tool to compare plans available both in your state and in other states. Before choosing a plan from another state, check your state’s tax site to make sure you can still get your tax incentives if you do.
- Always check plan sites for matching grant programs, where you may qualify to get extra money for the contributions you make, similar to a 401(k) plan. You may also find scholarship contests.
What are Coverdell ESAs (aka Education IRAs)?
Coverdell ESAs are investment and savings accounts that allow you to make up to $2,000 per year in after-tax contributions.
Factors to Consider
- This account’s main purpose is for saving for private elementary or secondary schools.
- The money in the account can also be used for college.
- These accounts can be tax-deferred and tax-free when used for qualified educational expenses.
- Even though there’s an income limit ($110,000 for single filers, $200,000 for married couples), they offer flexibility of investment options that other types of accounts don’t.
Learn more about what’s considered a qualified expense and more about the options above for saving for college at the IRS website. You’ll also find information about education tax credits – free money from the government toward your child’s education!
We hope this information was a good start to your research in finding the right college savings plan for you. If you want to learn more about saving for college and other ways to avoid debt and build wealth, you can also check out Dave Ramsey’s article titled “The Seven Baby Steps.” It has some great information about creating a financial plan for you and your family.
Have any savings tips you’re using to help save for college? Share in the comments below!
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