Saving for College - What Are Your Options

Student debt has reached an astounding 1.3T, and many young graduates are struggling to make a living as a result. Parents and society at large are now coming to grips with this fact and they are contemplating on how to help their children graduate from college without debt. The good news is that there are several ways to help you get started saving now, potentially saving your child (and you) from student loans down the road. However, the channel through which you save is a function of your residency, the age of your child, and a variety of other factors. Here are the options, and we encourage you to work with a financial professional like Mayanah to make the right choice. 

·            529 plans

·            State Funded Prepaid Plans

·            Coverdell Education Savings Accounts

·            Savings accounts, CDs and savings bonds

·            Roth and Traditional IRAs

·            Trust Accounts

The first step is to identify how much it costs to go to college.  The College Board reports that the average annual cost of tuition and fees can range from just over $9,000 annually for in-state residents at public universities, to more than $31,000 per year at private colleges. However, you need to bake in inflation, and relative increase in fees before you can identify an approximate amount.

One option is to use a College Savings Calculator.

529 savings plans

529 savings plan, which is the most education-specific savings plan, is a provision within IRS tax code to utilize tax-free savings for qualified educational expenses like tuition, books, and limited boarding. The new tax plan extends the use of 529 to schools, though we see no added advantage to a majority of people. Non-qualified expenses will incur taxes and a 10% penalty. Please note that the amount invested in 529 plan is after tax dollars, and carry the same risk/return as investing in mutual funds or ETFs. Hence, caution needs to be exercised while selecting the funds.

Some states offer state tax credits and provide matching funds to encourage college savings. However, states like Texas where state tax doesn't exist, this is not an option. Each state has its own 529 plans, and you can choose any state's plan and use it to pay for college in any state. The 529 plan is very advantageous for parents with very young children. But, what if your child is a few years away from going to college? Well, state-funded prepaid plans are for you.

State-Funded Prepaid Plans

Since 529 plan is a function of how the stock market is performing, there is a risk of losing money if your child is closer to going to college. For those in this category, you can enroll in state-funded prepaid plans, and you lock in future increase in price with today's fees. It's no surprise that college tuition rises an average of 5% annually, according to the College Board. So, in essence you are getting approximately 5% return on your savings.  For example, you might pay for eight semesters in today’s dollars, and that will allow you eight semesters in the future, even if the costs at that time are higher.

We highly recommend state-funded plans to also avoid many scams involved in this area. One resource is Texas Promise Funds. So in essence, here are the pros and cons for both 529 and prepaid plans.

Pros:

·         Tax-free growth. However, it can only be used for qualified educational expenses.

·         High contribution rates, generally with no household income limits or age restrictions. 

·         Beneficiary flexibility. The account can be designated, and changed in the future, for the benefit of any individual’s education expenses — even your own.

·         If the parent is the account holder, it is considered a parental asset, with little impact on financial aid awards.

Cons:

·         Since the 529 is dedicated strictly to educational expenses, if your child decides not to go to college, or qualifies for something close to a full ride with scholarships, the money may be unavailable for other purposes. 

·     State-Funded Prepaid Funds are restricted to specific colleges, and especially within the state. So, if your child decides to go to an out-of-state college, then the savings cannot be used.

·     Stock market exposure can impact returns in a down market, particularly if the down market is close to, or at time when you plan to tap the funds. 

Coverdell Educational Savings Account

Education Savings Accounts, or ESAs, is like a 529 plan, but with contribution limitations. Qualified withdrawals are tax-free and, and you can buy a wide variety of investments. But contributions are limited to $2,000 per year, and only until the beneficiary turns 18. And there are income limitations as well.

Although potentially meager in their growth potential, ESAs do offer more flexibility than 529 plans. Qualified expenses in Coverdell accounts can include educational expenses throughout the life of your child, from K-12 all the way through grad school.

Pros:

·         Can be used from K-12 through grad school.

·         High variety of available investments and tax-free growth for qualified expenses.

Cons:

·         Maximum contribution is $2000 per calendar year.

·        The beneficiary changes are not as straightforward as with a 529 account, and can vary by custodian.

Savings Accounts, CDs and Savings Bonds

Even though these are regular options, attractiveness is closer to zero. The return of investment we get through these channels do not keep up with inflation, nor the rise of college expenses. We highly discourage you to stay away from these options.

Pros: 

·         Investment flexibility

Cons:

·            Few, if any, tax benefits and low returns, many times well below the rate of inflation.

Roth and Traditional IRAs

Traditionally IRAs were considered as a retirement vehicle. However, recently, it has also been proven good for educational expenses. You also have the ability to invest in a virtually unrestricted array of stocks, bonds, mutual funds and exchange-traded funds of your choosing, with or without the aid of an investment advisor. Withdrawals from a Roth are allowed penalty free for qualified education expenses, though they will generally be included as income in determining financial aid eligibility. If you are investing in Traditional IRA, you can take a loan against the IRA for college expenses. However, tapping your account for qualified education expenses can permanently hinder your ability to stay on track for your retirement savings goal.

Pros:

·         If your child scores a bunch of scholarships and doesn’t require a lot of financial help, your retirement savings are allowed to stay invested.

Cons:

·    Contribution amounts are limited to annual maximums, and there are income restrictions as well for Roth IRAs.

Trust Accounts

There are 2 trust funds called UTMA (Uniform Transfers to Minors Act) and UGMA (Uniform Gifts to Minors Act). These are traditional accounts where assets are transferred to child’s account, and invested on his behalf until he reaches the “age of trust termination,” as defined by the state in which they live, usually between 18 and 21. However, as soon as they become adults, beneficiaries can do whatever they wish with the proceeds. And because the assets come under the student’s control, the value of the account will likely affect financial aid qualification.

Pros:

·            Flexibility to use the account for more than just college expenses.

·            Some tax advantages to the donor.

Cons:

·         Misuse of funds .

·         Beneficiary can’t be changed.

What is the best option?

 Well, there is no one answer. Usually it is a combination of options that have been explained here, and would be dependent also on the age, and aptitude of the student, as well as the state of residency. However, one thing is for sure. You need to start early. It is always beneficial to consult with a financial coach before you start your savings journey, or to assess where you stand with respect to your goals.