If you have been thinking about starting an education savings account for your child, then the start of a new year is a great time to incorporate this into your annual savings plan. Additionally, your children may have received holiday gift money from grandparents or family members, which could be a great option to seed your child’s education savings account.
As it relates to saving for your child’s education, I frequently receive questions such as:
- “Is a 529 plan a good idea for saving for our child’s education?”
- “What happens if our child gets a scholarship or even decides not to go to college?”
- “There’s so much unknown on what the future of college education will look like / cost – how much does it make sense for us to save?”
This post is going to address these questions and provide a framework for how I approach advising clients to save for children’s future education.
Types of Accounts
A 529 plan is a tax-advantaged savings account that allows for your contributions to grow tax-deferred, and distributions for qualified education expenses are tax-free. Qualified education expenses consist of tuition, books & supplies, and a laptop or other equipment for your student. You can also use 529 plans for trade schools and apprenticeship programs, if your child decides not to enroll in a traditional 4-year university program. Many states offer a state-sponsored 529 plan and some even provide a state tax incentive for funding these plans that you can claim on your annual tax return.
If you would prefer to set aside funds for your child that are not limited to education expenses, an alternative option is to establish a custodial account, also known as a Uniform Gift to Minors Account (UGMA). These accounts would be opened in an adult’s name “for the benefit” of your child. Once the child is no longer a minor (typically age 18), this account converts from the parent’s name to the child’s individual account. Your child would then have full discretion for how these funds are invested or spent once the account becomes available to them.
Investment Options
Similar to a 401k plan, a 529 plan offers a limited number of investment fund options that you can choose from. Most plans offer index fund options, as well as Age-Based Strategies. The Age-Based strategies are primarily invested in stocks while your child is young and then gradually shift to safer investments (bond funds & cash), as your child gets older & nears the age of needing these funds to cover education expenses.
For parents who opt for establishing a custodial account, these accounts can be established through a financial custodian (e.g. Charles Schwab, Vanguard, Fidelity). You would have access to more robust investment offerings and could allocate these funds however you desire. Unlike 529 accounts, custodial accounts do not offer tax-deferred investment growth. These are taxable accounts and are subject to “Kiddie Tax” rules. If the account generates more than $2,600 of investment income, the amount above this threshold is taxed at the parents tax rate. Tax efficient investments that don’t produce a lot of dividends or interest income are going to be the most attractive investments to hold within a custodial account.
Account Flexibility
529 plans can be used for private K-12 tuition, up to $10,000 per year, per child. If your state provides a benefit for 529 contributions, one option to consider is pre-funding the 529 plan with the annual tuition amount and then distribute money from the 529 plan to your child’s school. However, for couples who have the ability to cover private K-12 tuition through cash-flow, you can let the 529 funds continue to grow for postsecondary education expenses.
529 plans enable you to change the account beneficiary at any time, so if one child receives a scholarship or has a surplus in their account, you could reallocate these funds to another child or even pass this account down to the next generation for a grandchild to benefit. Additionally, 529 plans can be rolled over to a Roth IRA (tax-free retirement account) for the original beneficiary, up to a lifetime maximum of $35,000. This could be a great head start for your child & help teach them the power of investing for their financial future!
If money is distributed from a 529 plan for a non-qualified expense, then any growth on the investments would be subject to income tax and a 10% penalty. However, your original contribution can be withdrawn tax & penalty-free. Given the flexibility of reassigning the account to another beneficiary or rolling over funds into a Roth IRA for your child, I tend to view a non-qualified distribution as a “last resort” option.
Custodial accounts possess ultimate flexibility for the funds within the account, so for parents who desire to allocate a portion of discretionary funds to help give their child a “head start” as an adult, this can be a great avenue for doing so. Since the account will convert into your child’s name upon reaching age 18, it’s important to assess if you’re comfortable with your child having full discretion over how this money is used.
For parents who are hesitant to establish an account dedicated for educational purposes and also don’t like the idea of their child having full reigns over an account at age 18, an alternative option would be to invest for your child in your brokerage account. You have the ability to use these funds for their education or even provide gifts to your children in increments that you feel comfortable with as you observe how they handle money upon becoming a young adult.
Deciding What Makes Sense for You
Given the tax-deferred growth of money invested within a 529 plan, these accounts are most powerful when your child is young and can reap the benefits of 10-15+ years of investment growth. With this in mind, it can make sense to “front-load” 529 plans if you receive a cash bonus or have a liquidity event for your equity, if you have children under the age of 5. Additionally, if your state offers a tax benefit for contributing to a 529 plan, funding up to the annual benefit amount can lower your state taxes while fulfilling your desire to save for your child’s future education. For parents who value financially supporting their children’s education, 529 accounts are great vehicles to incorporate within your annual savings plan.
For those who desire additional flexibility and are comfortable with their children having the ability to make financial decisions upon turning age 18, a custodial account may be a better route to pursue. Both of these accounts can have a place within your financial plan, so I encourage you to reflect on what is the primary purpose for your money and use this as your guiding light for selecting which accounts to fund and how much to allocate to these accounts.