How to Save for a Child’s Education

With the average cost of college tuition rising every year, more parents than ever are looking to save for their child’s higher education in advance. A little preparation can go a long way, and if you have the income to invest now, there are a few approaches you can take. Read on to learn more about the best way to save for a child’s college.

How Much to Save

Before you can even begin to think about the best way to save for your child’s higher education, you should know approximately how much money you’ll need to save. It can be hard to come up with a specific number, especially when you consider the effects of inflation and rising tuition costs.

A lot of experts recommend saving the average cost of a full, four-year college education in the year your child was born. If you invest and save years ahead of time, you can increase the potential for compound interest to work in your favor. Saving early raises the likelihood that your investments can yield returns that can cover the future costs of college, ensuring your kids don’t have to take on too much student loan debt.

Even if you can’t save the full amount of their future tuition, saving and investing now can give them a huge boost later! Don’t underestimate the power of your forethought—your future self is probably going to thank you.

Types of Investments

Once you’ve estimated the amount to save, it is time to decide which method of saving you want to use. There are a few investment and savings vehicles that might work for you and your family’s situation. There is no one right way to invest, but there are specific options that have tax advantages and benefits.

529 Plan

529 plans are the most popular method for saving for a child’s college education. They are sponsored by state governments, but you’re not limited to your own state’s 529 plan. You can shop around and invest in another state’s plan if you like it better. Here are just some of the details:

• Contributions to 529 plans are made with after-tax money, like a Roth IRA.
• These plans are tax-deferred, which means the earnings on the investments grow tax-free.
• This also means your child won’t have to pay any taxes when it comes time for them to use the money – as long as they spend it on things that are considered qualifying education expenses. These include tuition, room and board, meal plans, books, and more.
• Some states allow this money to be spent on primary or secondary school tuition, but not all—it’s important to check the details of any 529 plans you’re looking at.
• If the funds are used for primary or secondary school, there is typically a $10,000 withdrawal limit.
• Depending on how much you contribute over a single year and five years, your contributions may be subject to the gift tax.

Coverdell Education Savings Account

A Coverdell Education Savings Account (ESA) is a tax-deferred trust account that can be used to save and pay for education, including elementary, secondary, and higher education.

Similar to a 529 plan, the earnings accumulate tax-free, and withdrawals are tax-free as long as they are used for qualifying education expenses.

There are more limits on a Coverdell ESA:

• These accounts can only be contributed to until the beneficiary reaches the age of 18.
• The savings must be distributed by the time the beneficiary turns 30.
• The maximum contribution that can be made per year is $2,000, and there are income limitations.
• Multiple accounts can be set up for a single beneficiary, but the limit remains $2,000 per beneficiary per year, across all accounts.

Custodial Accounts

Custodial accounts — Uniform Gift to Minors Act (UGMAs) and Uniform Transfers to Minors Act (UTMAs) — allow you to put money in a trust for a child or grandchild and manage the account until the child reaches the age of 18 or 21 (depending on the state). There is no limit to the amount that you can put into these accounts, and there are also no rules that dictate what the money can be spent on once the beneficiary gains access to the funds.

Something very important to note about this method of saving is that money saved in these accounts will be reported as the students’ assets on the FAFSA, rather than parental assets. The formula that determines federal financial aid expects students to contribute 20% of savings, but only expects parents to contribute 5.6% of savings. Thus, saving for your child’s education in custodial accounts could negatively impact the child’s eligibility for need-based financial aid.

Roth IRA

Roth IRAs are most commonly used to save for retirement, but many people do not know that they can actually be used for other things like saving for your child’s college education. Similar to a 529 savings plan and a Coverdell ESA, Roth IRAs are tax-smart investment vehicles because they allow you to grow your savings tax-free and make tax-free withdrawals. Also, if you choose to save using a Roth IRA and your child ends up not going to college, you can just use those funds for retirement instead. Using a Roth IRA to save for a child’s education can be complicated, however, so it is best to talk to a financial adviser if you want to learn more about this option.

Permanent Life Insurance Policy

This is a savings method most typically used by higher net worth families because it provides an avenue for tax-advantaged savings that can be used for multiple purposes, including education. With a permanent life insurance policy, some of the money you pay for your premium goes into the death benefit, while some of it goes into a tax-deferred savings account. This method of saving is way more flexible than something like a 529 savings plan, because the savings do not need to be used strictly for a child’s college expenses. Also, these savings are not accounted for in financial aid calculations. If you’re thinking about using permanent life insurance to save for your child’s education, it’s a good idea to talk with a financial adviser.

Choose a Plan and Start Saving

Trying to determine the best way to save for a child’s education may be overwhelming, but don’t let the multitude of options scare you away — the most important thing is that you start saving as soon as possible so your investments can grow. Speaking to a financial adviser can be really helpful, especially if you have other retirement and investment accounts to consider.