Whether your child is taking their first steps or headed to their first day of kindergarten, it can seem like time is flying by too fast.
Before you know it, your sweet little toddler will be headed off to college, which leaves you with one very important question: How will you pay for it?
It’s no secret that a college education is expensive, and for the parent still buying diapers, the prospect of paying for college can be daunting. The good news is that the sooner you start saving — even if it’s just a little bit each month — the more you will have when your child is ready to fly the coop.
“Time is what really matters,” says Peter Dunn, aka Pete the Planner, an Indianapolis-based personal finance expert. “Twenty-five dollars, $50 or $100 per month is a good place to start. Running a calculator, $100 per month matters — that really pays off.”
While putting money into a savings account starting today can be a smart move, there are several savings plans, such as 529 Plans, Roth IRAs and Coverdell Education Savings Accounts (ESAs), that will help each dollar saved go even further by offering tax-free earnings that can be used toward college expenses.
Consider Your Options
When looking at savings plans, it’s a good idea to have a basic understanding about how each operates so you can make the best financial decision for your family. Here are some factors to consider with each.
Each of these college savings plans has restrictions on how earnings can be withdrawn. While contributions for each of these accounts can be withdrawn at any time tax-free because the money is contributed after taxes, it’s important to remember that all withdrawals are a combination of contributions and earnings. To get the most bang for your buck, it’s wise to try to stay within the plan’s withdrawal guidelines to avoid unnecessary taxes and fees.
When your children are young, it can be hard to know what your savings capability will be like and what type of college they will want attend, if they attend at all. Having an understanding of the flexibility you have with each account in regards to how withdrawals can be used, if accounts can be transferred, and how much you are allowed to contribute each year will help you make the best decision for your family.
How your FAFSA will be affected
Depending on the plan and who holds it, withdrawals may count as income that could put a dent in your financial aid possibilities. While this isn’t something to dwell on — money saved is better than money borrowed, after all — it’s something to consider if you anticipate needing additional help.
If you need some guidance in making investment decisions, it can be a good idea to seek out the advice of a financial planner or tax advisor. These professionals can help you think through these variables and others.
A Look at the Plans
Let’s take a closer look at the plans. Bear in mind that these aren’t the only options you have when it comes to saving for your children’s education, but these plans all offer college savings incentives that will benefit you over time.
State 529 plans are the most popular college savings investment option. While many states, including Indiana, offer tax incentives for using an in-state plan, you can open a plan in any state for use at qualified universities and colleges throughout the country. 529 plans have limited investment options but offer quite a bit of flexibility compared to the other plans listed here, including high contribution limits (currently $15,000), no age limits for distributions in most states, and easy transferral to another family member (including parents) if the student doesn’t use the funds. For students receiving scholarships, earnings can be withdrawn for non-qualified uses tax- and penalty-free.
Roth IRAs are typically used for retirement savings, and therefore earnings are subject to a penalty if withdrawn before the account holder is 59½ years old unless used toward qualified educational expenses. Advantages of a Roth IRA over a 529 plan include wider investment options and flexibility with contribution withdrawals. On the flip side, there are contribution limits ($6,000 under age 50) and withdrawals count as income on your financial aid application.
Like the Roth, ESAs have a wider investment portfolio than the 529, but the downside is they are extremely limiting in their contributions — only $2,000 per year per student — and all contributions made after age 18 are subject to an excise tax. Also, all funds must be used by age 30 or transferred to another beneficiary to avoid penalties.
Keep the Conversation Open
While your children are still young, there are a lot of unknowns about the future. Will they attend a state or private school? In-state or out? These variables can make saving feel a little like a gamble. Instead of focusing on the specifics, focus on their goals for the future. By keeping the conversation about college open, you’ll be able to better plan over time, as well as help your child make a college decision that makes sense for your family’s financial situation, perhaps by finding a less expensive program that will help them meet their career goals. And bear in mind, putting money away, whether for college or for another goal, can never hurt.