Where Do I Save for My Child’s Education?
Are you trying to figure out where to save for your child's education? You are likely trying to weigh the pros and cons of all your education planning options. It is usually best to deploy a strategy that includes different account types. Using a blend of accounts can reduce the risk of unwanted penalties and taxes.
Here are the most common savings vehicles to help you save for your child's education. Here is a brief list of each of those options you may be able to use for education:
529 Saving Plans
Individual taxable accounts
EE and I Bonds
Carefully consider the unique characteristics of each before executing an education savings plan. To get the most benefit out of these options– start early!
529 Saving Plans
529 plans are tax-advantaged savings plans specifically designed to create an investment vehicle to pay for education expenses. 529 plans are not just for college – tax-free withdrawals may also include up to $10,000 per year in tuition expenses for K-12 schools. State tax treatment of K-12 distributions varies. Although contributions are not deductible at the federal level, earnings grow federal tax-free, and there is no federal tax on qualified withdrawals to pay for college. Depending on your state, you may be able to deduct contributions from your state taxes.
All 529 plans have a plan manager, usually a financial services firm, that manages the portfolio of investments. You'll likely be able to create a portfolio from an offering of mutual funds and ETFs and tailor it to your time horizon and investment preferences. You and your spouse (and anyone else who wants to – it's not limited to parents) can contribute up to $16,000 per year each (in 2022) and still fall under the gift tax exemption.
You can fund the account with five years' worth of your annual exclusion gifts, so your child's 529 can begin with a balance of $80,000. When the funds are distributed for and used for qualified education expenses, the amount distributed is free of tax and penalties.
Coverdell accounts are less popular than 529 plans. But they are also a tax-advantaged account designed for assisting families in paying for education expenses. The max that may contribute to a Coverdell is $2,000 per year. This annual contribution cap can be a significant disadvantage for Coverdells compared to other options. This annual max is the total amount allowed independently of who contributed (a key difference from the 529 plan).
Coverdells do not provide a tax deduction, but the assets accumulate tax-deferred. When the funds are distributed for and used for qualified education expenses, the amount distributed is free of tax and penalties. You may use funds from the Coverdell for qualified expenses for both K-12 and university.
Contributions are subject to income phaseouts, and you may only contribute when the child is younger than 18. You must distribute all the funds from the Coverdell ESA by the child's 30th birthday.
For future education expenses, you may use custodial accounts opened under the Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). The adult custodian must manage the assets in these accounts for the child's benefit. And when the child reaches the age of maturity (dependent on state law), the child receives complete control of the assets. So, you may want your child to use the money for school, but if they have reached the age of maturity, it is within their power to do whatever they wish with the funds. A contributor can contribute no more than $16,000 a year to avoid gift taxes. As the custodian of this account, you also need to be careful about managing any kiddie tax. UGMAs and UTMAs do not offer any tax advantages.
An individual or joint brokerage account owned by you, the parent(s), can be a great way to save. There are fewer rules than 529 or Coverdell accounts with a taxable account. Maybe you would like this kind of account because there is more flexibility. Because these are not tax-preferred accounts, you won't face the penalties associated with 529 or Coverdells for not using the funds for qualified expenses. Furthermore, you retain control of the account even after the child has reached the majority age. You are the account owner, after all. But there are no special tax breaks. However, you can manage tax exposure in these accounts with low-cost tax-efficient investment options and tactics.
Are you trying to figure out where best to save your hard-earned money? Download our 18-point checklist, which outlines the accounts you should consider if you want to save more.
EE and I Bonds
EE and I Bonds are bonds sold directly for the US Treasury. These bonds accrue interest, and you can avoid taxes if you use the interest earned from the bond for qualified higher education expenses for a dependent or child. However, if your income is higher than a specific limit, you may still owe taxes on the interest used for qualified expenses. Carefully review the interest rates offered on these bonds, as sometimes the rates are competitive, and sometimes they are not.
Individual Retirement Accounts
You can use retirement accounts for qualified education expenses. However, it is not usually where you want to pull funds for education. Before your begin to plan on using your retirement accounts for your children's education, you need to make sure you are saving enough and will have enough for retirement. The unfortunate truth is you cannot borrow money for retirement. However, your child can borrow money for their education. I have seen some scenarios where, with proper planning, it makes sense to use retirement accounts for education. But this requires careful consideration as taxes and penalties can be involved if not correctly executed.
You can set up your accounts and plans as soon as there is a little person to benefit from them, so starting before the child's first birthday is ideal. The sooner you begin saving for your child's education, the better. A financial planner can assist you in setting these up and selecting appropriate investments based on your time horizon and goals.
Working with a trusted financial advisor can reduce your stress and help you map out the best course of action for your situation. Are you trying to figure out what savings strategy is best for your child's education? At Pursuit Planning and Investments, LLC, I help you think through your options. I ultimately help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your goals and begin best optimizing your financial plan in that meeting.
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