Why It’s Never Too Early to Start Planning for College
Saving is a huge part of planning for college. More families are saving for college in 2016 than in the prior three years.¹ The payoff for getting a head start is big: Parents who plan ahead may have the means to spend more on college, while borrowing much less.
This is critically important because the average cost of a college education continues to rise. The price of tuition, fees, and room and board at a public, four-year college, for instance, has outpaced inflation for several decades, reaching an average in-state cost of $20,092 in 2016–17.² Costs at private institutions top $45,000.
Not surprisingly, the typical student debt load is alarmingly high. Graduates today carry an average of $28,100³ in debt along with their diplomas.
Your best approach is to start saving early. You’ll have time to select investments that have the potential to outpace college inflation. Plus, you may benefit from compounding, which can help grow your child’s college fund over time.
Example: Say you sock away just $200 a month as your child grows. After 17 years, assuming your investments return 8 percent annually, you would have invested just over $40,000, but you will have almost $87,000 in your child’s education fund.
7 Ways to Create a Winning Game Plan
How do you get started? Here is a brief overview of seven tax-favored choices for investing your college money.
1. 529 college-savings plans. These state-sponsored investment accounts, named after the tax-code section that created them, let you shelter college savings from federal (and usually state) income tax. Although you don’t get a deduction for your contributions, earnings are tax-free if you use the money for qualified education expenses such as tuition, fees, room and board, and textbooks.
Currently, there are more than 50 different plans because many states offer more than one – and most are open to residents and nonresidents alike. Unlike other education-savings programs, 529s let you participate no matter how much you earn, and the states set generous limits on total contributions – in many cases more than $300,000. To invest, you select one or more of the plan’s portfolios that are managed by financial companies. You can use the funds at any college in the U.S. or abroad that’s accredited by the U.S. Department of Education and, depending on the individual plan, even for graduate school.
2. Prepaid tuition plans. These plans – distant cousins to 529s – let you buy tuition at a state college or university years before your child is ready to attend, essentially locking in today’s prices for use in the future. They share the same federal and state tax advantages as 529s and are open to everyone regardless of income level. In addition, a group of nearly 300 private colleges and universities offers a prepaid tuition program called the Private College 529 Plan. Prepaid plans can be run either by states or colleges. However, your child is generally limited to your own state’s plan and to the colleges that participate in that plan.
Prepaid plans come in three varieties: contract plans, in which you pay upfront to cover tuition and fees for a semester or a year; unit plans, in which you buy units equal to a portion of the average annual tuition and fees at your state’s public institutions; and voucher plans that sell certificates you redeem for a percentage of tuition or fees at participating public institutions. Contract plans are the most common.
3. Coverdell Education Savings Accounts. Offered at participating banks, mutual fund companies or brokerage firms, you can open one of these accounts for any student under age 18. Anyone can contribute, but the total amount of contributions for each child can’t exceed $2,000 a year. As with 529s, your money grows tax-deferred, and you avoid tax on the earnings if you withdraw the money for qualified educational expenses. But with Coverdells, “qualified” covers a broader range, including expenses at elementary and secondary schools (K–12), and at public, private, vocational, or religious schools.
Your ability to open a Coverdell, however, does depend on your income. You’ll qualify if you have a Modified Adjusted Gross Income (MAGI) of less than $110,000 (or less than $220,000 if you’re married filing jointly).
4. Roth IRAs. Though technically not a college savings account, some parents also use Roth IRAs to save and pay for college with tax-deferred earnings. Contributions can be withdrawn penalty- free and tax-free at any time. Earnings on those contributions can also be withdrawn penalty- free if you use them to pay qualified education expenses (but tax would still be due if you are younger than 59½ at the time of the withdrawal).
Be aware that not everyone is eligible to contribute to a Roth – it depends on your income. In 2017, if your filing status is single or head of household, you can contribute the full $5,500 ($6,500 if over 50) to a Roth IRA if your MAGI is $118,000 or less. And if you’re married and filing a joint return, you can contribute the full $5,500 ($6,500 if over 50) if your MAGI is $186,000 or less.
5. Custodial accounts. Often called UGMAs or UTMAs, after the Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act, these custodial accounts let you set aside money or other assets in a trust for your minor child. As trustee, you manage the account for your child until he or she reaches “legal” age – 18 or 21, depending on your state. At that time, the child can use the assets for college or anything else. The idea is that because your child is in a lower tax bracket than you, you’ll reap some tax savings compared to if you held the assets in your name. This strategy is very limited, however, because of what’s called the “kiddie tax” – rules that apply when a child has unearned income. Under these rules, full-time students under age 24 are generally taxed at their parents’ tax rate on any unearned income over a certain amount. In 2017, this amount is $2,100 (the first $1,050 is tax-free and the next $1,050 is taxed at the child’s rate).
6. U.S. savings bonds. Series EE and Series I bonds are a safe, tax-favored way to save, and offer a special tax benefit for college savers. You can buy them at most banks and savings institutions or directly from the federal government. If used to pay qualified education expenses (as well as a few other minor requirements), the bond’s earnings are exempt from federal income tax.
To get the education break, you must be 24 or older when you purchase the bond and only bonds purchased after 1989 qualify. You must also meet the income limits. In 2016, the exclusion started to phase out at MAGI of $116,300 for married couples filing jointly and at $77,550 for single filers.
7. Life insurance. While the primary purpose of life insurance is to provide a death benefit to beneficiaries, it can also be used to help fund a college education or other expenses while the insured is living. How does this work? Policies that accrue cash value will generally allow you to access a portion of that money tax-free through either policy loans or withdrawals. Of course, certain conditions and limits exist, and you should always check the terms of your policy to make sure you understand what those are.*
In addition, one type of cash-value policy, known as Indexed Universal Life (IUL), provides an opportunity to accumulate cash value at a rate of return that is linked to a market index. Your cash value has the opportunity to grow when the index performs well, yet you also have safeguards to protect against negative market fluctuations. With this design, you may benefit from market growth without having to worry about market losses.
*Policy loans are subject to interest and policy loans and withdrawals will reduce the cash value and death benefit.
1 Sallie May (2016) Web page: How America Saves for College. Retrieved December 27, 2017, from https://www.salliemae.com/research/how-america-saves-for-college/
2 The College Board (2016, October) Web page: Report: Trends in College Pricing. Retrieved December 27, 2017, from https://trends.collegeboard.org/sites/default/files/2016-trends-college-pricing-web_0.pdf. 2 .Trends in College Pricing 2016, The College Board.
3 The College Board (2016) Web page: Trends in Student Aid 2016. Retrieved December 27, 2017, from https://trends.collegeboard.org/sites/default/files/2016-trends-student-aid.pdf
Mutual of Omaha Investor Services, Inc. and its representatives do not provide tax advice. Consult with your tax advisor regarding your specific situation.