Educational Accounts: 529 and Coverdell
Tuition for college or university has risen at a rate faster than inflation every year since 1981. In 2017, average in-state tuition and fees cost $9650 per year, out-of-state cost $24,930 per year, while private universities cost an average of $33,480 per year. It can be daunting to think about how you are going to help pay for your child's college or university, but there are ways to help you save.
There are primarily three different ways to save for a child's future educational costs: traditional investment accounts, Coverdell accounts, and 529 plans.
TOP TIP: It is important to note that withdrawing money from your 401(k) or IRA in order to pay for your kids' college is not recommended. Not only do you have to pay penalties on the money you withdraw, but you may find yourself starting over with saving for retirement at a time when you should be shifting the focus of your portfolio to preparation for retirement, meaning lower risk and therefore lower yield investments. But if you start saving for your kids' education early enough, even small amounts can add up to make a big difference.
The most common way that people save for their children's education is also the simplest. You can open a regular investment account, and invest in the stock market, ETFs, or other products, then cash those in when it is time to pay for college. There are no minimums, no limits, and no restrictions upon how the money can be spent. It is the most flexible way of saving. You can make a single deposit, regular deposits, or occasional deposits on your own schedule. However, the money is all taxable, and subject to the ups and downs of the stock market. It is for this reason that you may want to discuss specific educational savings accounts with your advisor.
Coverdell Education Savings Accounts, formerly known as Education IRAs, are set up to fund a child's higher education expenses. They are ideal for modest income families who may not be able to make large lump sum contributions, but still want to set up some savings for their child's education. Anyone earning up to $110,000 per year or $220,000 for couples filing jointly can contribute, but contributions can total no more than $2000 per child per year up to age 18, so it is best to start a Coverdell account early. After age 18, no more contributions can be made, though funds will continue to accumulate until they are withdrawn. Distributions are tax-free, and can be used to pay for tuition, books and mandatory materials, as well as room and board. The entire account must be distributed by the time the beneficiary reaches age 30, or rolled over to another beneficiary within the same family at that time; they cannot be transferred before then, unlike the 529.
There are two types of 529 plans: pre-paid tuition and college savings plans.
- Pre-paid tuition is just how it sounds - you lock in today's tuition prices, and pre-pay for units or credits that will be exchanged for future tuition, and sometimes even the cost of room and board. Some states have residency requirements for either the account owner or the beneficiary, while others allow for non-residents to invest in their plans.
- College savings plans are set up on behalf of the future student in order to pay for future eligible expenses. You get the option of choosing between several investment options, as with a regular investment account, including some age-based portfolios which will even automatically shift to more conservative investments as your child grows older and comes closer to the age where they will need to withdraw the money, protecting them from ups and downs in the market. These can typically be used at any college or university to pay for tuition, fees, room and board, and mandatory materials like books or lab equipment.
With both types of 529 plans, you choose the investment when first opening the plan, and then all future contributions will be added to the initial investment unless you roll it over into a new plan. These plans are particularly advantageous for high income earners. Distributions are non-taxable, provided the money is used for qualified higher education expenses. All contributions must be made in cash, not stocks or bonds, and anyone can contribute to the plan, not just the original contributor. Some plans have a maximum contribution limit equal to the maximum tax-free gift amount of $14,000 per year, with the option of making a one-time contribution of $70,000, but then you cannot make any more contributions for five years. Many college savings plans also have contributions limits of around $300,000 total, meaning that if you max out the annual contribution every year, with a 5% rate of return, your child's 529 account would max out after 14 years, or after 13 years of contributions if you start with the lump sum option! 529 plans are also very flexible, with no age minimum or limit for either contributing or withdrawing funds - you could even start one for yourself if you want to go back to school in a few years. 529 plans also allow you to change the beneficiary of your plan, so long as they are within the same family, meaning that if your child gets a full scholarship, that money can go to a sibling or other relative instead.
What really matters is starting early. If you save nothing, you will have nothing extra when your child turns 18, and may be tempted to dip into your retirement account. But even single or modest contributions made early on can help out down the road. In the chart above, you can see how the different accounts can benefit your child. Assuming a modest 5% rate of return, a one-time $5000 contribution will turn into $12,033 over 18 years, while a contribution of $100 per month will net $35,311 by the time your child turns 18.