Where To Save For Education Expenses
August 13, 2015Back-to-school season may seem expensive but it’s nothing compared to when that will include tuition and room and board. However, saving for those future education costs can be confusing since education planning doesn’t get as much attention as other topics like retirement and there are a lot of different education saving options out there. Let’s take a look at some things to consider:
1)Should you even be saving for education right now?
With the rising cost of college and stories of graduates buried under mountains of debt, you’d think this would be a no-brainer. But the reality is that there are some other goals that might take priority. If you don’t have enough emergency savings to cover at least 3-6 months’ worth of necessary expenses, consider taking care of that first since taking money out of education accounts for an emergency can result in investment losses and tax penalties. If you have any debt with interest rates over 4-6%, consider paying that off beforehand as well since you’ll likely save more in interest than what your investments will earn. Finally, make sure you’re on track for retirement before putting away money for education since they don’t exactly award financial aid for retirement.
2)How much flexibility do you want with your education savings?
Earnings in tax-advantaged accounts like Coverdell Education Savings Accounts and 529 savings plans can be subject to a 10% penalty if you use them for something other than qualified education expenses so if you think you might want to use the money for something else, you might want to look elsewhere. One option is an IRA, which can be used penalty-free for education, a first-time home purchase (up to $10k), or retirement (after age 59 ½). Another is US government savings bonds which can be tax-free for education expenses.
Finally, you can simply invest in your child’s name. The first $1k of earnings each year is tax-free and the next $1k is taxed at your child’s rate. (Anything above that is taxed at your rate.) However, the money has to be used for your child’s benefit and they can use it for whatever they want once they reach the age of majority in your state. Assets held in your child’s name also reduce financial aid eligibility by about 20% compared to 5-6% at most for assets in your name.
3)Are you saving for private elementary or high school expenses?
If so, the Coverdell Education Savings Account (ESA) will likely be your best bet since it’s tax-free for those expenses in addition to college and graduate school. It also has the advantage of letting you choose almost any investment you want. There are income limits but you can get around them by gifting the money to your child and having your child make the contribution. Just be aware that if you use the money for other purposes, you may have to pay taxes plus a 10% penalty on the earnings. You can find low cost Coverdell ESA providers here.
4)Does your state offer a state tax deduction for contributions to their 529 savings plan?
If your state offers a state tax deduction, see if your plan is listed in the “Honor Roll” on this guide to the best 529 plans. If so, you’re in luck. If not, the plan’s poor investment choices may outweigh any tax benefits you can get by contributing to the plan. As always, don’t let the tax tail wag the dog.
If your state doesn’t offer any state tax benefits, you can make your decision purely on investment choices. You might want to contribute the first $2k (the maximum per year) to a Coverdell ESA for the broader choice of investment options (you can invest a Coverdell brokerage account in practically any stock, bond, or fund you want) or just stick to one of the 529 plans listed with “Dean’s List with honors” at the site above. One advantage of 529 plans is that they generally have fully diversified age-based allocations that automatically become more conservative as your child approaches college-age. The West Virginia and Utah 529 plans also include DFA funds, a specialized group of index funds that are normally only available from DFA-approved advisors. Finally, programs like Upromise let you and family and friends earn shopping rewards that can be automatically contributed to a 529 savings plan.
Saving for education can feel like it requires an education itself. Don’t let analysis paralysis bog you down in procrastination though because your kids will grow up faster than you can imagine. Keep in mind that any saving is better than no saving so perhaps the most important thing is to just get started.