Saving for Your Child’s Future
posted Dec 3, 2018 by Paul Nadeau Jr., CPA, MST in the Global Tax Blog
* This blog was orginally published in 2015 and was updated in December 2018.
Saving for your child’s future is not always at the top of most new parents’ priority list. It’s challenging to think about long-term goals like saving for college when finances are tight while shelling out money for diapers and child care. College tuition costs are on a steep incline at twice the rate of inflation. Sending your child to college in 20 years is projected to cost more than $200,000 at an in-state university and almost $500,000 for a private college.
The good news is that if you start saving early, your money has time to grow and there are a number of tools to help parents defray the cost of a child’s education. Here are a few options you can consider to help you start saving.
529 Savings Plans
A 529 plan is an education savings plan operated by a state or educational institution. These plans are relatively hands off and work much like a 401k or IRA with your contributions invested in mutual funds or similar investments. Your account will go up and down in value based on the particular investment’s performance in the stock market. If the market takes a nose dive, your plan could too.
The major advantage of the plan is its tax benefits. Although contributions are not deductible federally, earnings in a 529 plan grow tax-free and will not be taxed as long as the money is withdrawn to pay for specific college-related expenses such as tuition, fees, room and board, and course materials. Money withdrawn and spent on unqualified expenses is subject to income tax and a 10% penalty on the earnings.
You can switch beneficiaries within the plan. If your firstborn opts out of the college route, a younger sibling can become the beneficiary of the plan without penalty. Another great benefit is that the plan is considered your asset, not your child’s. This will help your child get more financial aid when applying to schools.
There is no income limitation to take advantage of these plans. However, the contributions are considered gifts to the beneficiary of the plan. Currently, you can make up to $15,000 ($30,000 if split with your spouse) in gifts each year to any person and not be subject to the gift tax. The 529 plan allows you to make an election to front load the contributions of up to $75,000 per beneficiary (or $150,000 for a married couple) and treat it as if it was made ratably over a 5 year period. This avoids any gift tax because you are under the $15,000 annual exclusion for each of the 5 years.
An added benefit is that these funds are considered to be removed from your taxable estate, yet you retain full control over the account including the right to change beneficiaries. Each estate plan differs in the maximum value allowed for each beneficiary. For most plans the maximum is between $300,000 - $400,000. 529 plans are not only a great way to save for college but also a powerful estate planning vehicle.
The Tax Cuts and Jobs Act (TCJA) has modified 529 plan rules. The new law now allows such plans to distribute up to $10,000 for expenses related to tuition for elementary or secondary public, private, or religious schools. This limitation applies on a per-student basis. A student may be a designated beneficiary of multiple accounts but may only receive a maximum of $10,000 in distributions across all accounts for the tax year. As private K-12 school tuition rises similar to college tuition, this could be a great option to help defray the costs.
Prepaid 529 Plans
A prepaid tuition plan is an alternative to a 529 savings plan and is designed for parents who are sure that their child will attend an in-state university. These plans generally allow parents to pre-pay college tuition and lock in the cost at today’s rates. The current state of increasing tuition costs makes this a valuable tool. The prepaid plan still maintains the same tax and financial aid benefits as the 529 savings plan but is not subject to the stock market volatility.
The major limitation to a prepaid plan is if your child decides to go to an out of state school. They will still get a return on their money but the value of the savings will not be nearly as great as if it were used to pay for the intended college. Make sure to compare each of the prepaid plan options available to you. The requirements can vary greatly from plan to plan.
Coverdell Education Savings Accounts (ESAS)
These accounts are similar to 529 Plans because the earnings can be withdrawn tax free. However, with ESAS you can invest your money any way you want with no restrictions. Also, the withdrawals can be used to pay for costs other than college.
For example, you can use the funds to pay for elementary and/or high school tuition as well as after school programs and textbooks. The downside is that plans are subject to annual income limitations and only $2,000 per child per year can be contributed. Time limits are also imposed. Contributions cannot be made past the child’s 18th birthday and the funds must be utilized before the child turns 30.
Roth IRA Accounts
Once your child gets a little older and has earned income, you can open a Roth IRA in the child’s name. Each year you can contribute the lesser of the child’s earned income or $5,500. The contributions are made with after-tax money and the assets grow tax-free. Children over 18 retain control of the account, but restrictions prevent the account holder from taking withdrawals until the age of 59 ½ penalty free. There are a few exceptions to the withdrawal restrictions. Funds can be taken out tax free for the purchase of a first home or for qualified education expenses. Roth IRA’s are a great way to give your child a head start for more than just their education.
Discuss Financial Goals
Before making a decision on a savings plan or investment options, it is critically important that you discuss your own long-term financial goals. You don’t want to save for your child’s future, only to become a financial burden to them later in life because you didn’t plan for yourself. Also worth consideration is how you plan to teach your children about money and their future. Even if you can afford to fully pay for their education, it is best to involve them and have them contribute in the process. This will help them learn long-term saving skills that will have a major impact on their financial futures.
Questions about how to start saving? Contact us.