Strategies to Know Now About Saving for College (2/6)

Welcome to week number two of my saving for college blog series! Previously, I wrote about the high cost of attending college. Today we’ll look into savings strategies to use while college-bound children are growing up. Over the next several weeks I’ll post about the cost of secondary education and the ways to academically and financially prepare.

Week 2: Birth – Age 18: 529 Plan vs Uniform Transfer to Minor Account (UTMA)

Last week we uncovered that a child born today might need $189,638 ($111,392 in today’s dollars) by his 18th birthday in order to pay for 4 years of public college education.  The costs could be significantly higher for private college, or an out-of-state school!  Luckily through the power of compounding interest, it is possible to save this sum with a “low” monthly payment… IF YOU START EARLY!!!  Or I should say, the earlier you start the lower your monthly payment, but it’s never too late to start! Let’s assume a family is starting with no savings, but can achieve a 7% return invested in the financial markets.  Consider the following four examples:  one family started saving at birth, the second at age 5, the third at age 10, and the fourth at age 15.

Child’s Age Monthly Savings Months Remaining (Years) Rate of Return Balance at Age 18
     0 $440.28 216 (18)      7% $189,638
     5 $748.58 156 (13)      7% $189,638
    10 $1,479.25 96 (8)      7% $189,638
    15 $4,749.25 36 (3)      7% $189,638

Don’t let this chart scare you off.  We’ll discuss scholarships, grants, student aid programs and loans in the coming weeks.  Just know that saving for college is doable, and it is significantly easier to do the earlier you start.  This goes for just about every savings strategy and financial goal around.  My high school economics teacher used to preach, “It doesn’t take money to make money, it takes time!”  So true.  You could begin to save for college expenses using your own savings account or investment (brokerage) account, but there are two unique types of accounts that can offer some powerful benefits:  a 529 Plan, and a UTMA.

529 Plan

A 529 Plan is an investment account organized by each state that makes it easy and beneficial to save for college.  Some Plans will let you deduct your contributions from your state income taxes.  Earnings within the account will grow tax-free, and distributions, if made for qualified higher education expenses, are also never taxed at either the State or Federal level!  Qualified expenses include tuition, fees, room, board, books, supplies and required equipment.  These tax advantages make the 529 Plan your first-stop for college savings. 529 Plans make monthly contributions a breeze.  You can set it up for an automatic monthly deposit with an automatic investment, and in the words of Ron Popeil, “set it and forget it!”  In the future, you remain in complete control of the funds and how they are used.  Some plans allow for third-party contributions so even Grandma and Grandpa can get in on the action without having to open their own account.  Every state’s plan is a little different, so be sure to find out if there are any unique stipulations to receive a tax break, limits on investments within the plan, limits on annual contributions etc. before you choose.  Sometimes it’s best to use your own state’s plan, but some states allow the freedom to use any plan around.  It’s also usually pretty easy to move between accounts, so don’t let indecision stop you from moving forward!

UTMA (Uniform Transfer to Minor Account)

An UTMA is an account in the name of a minor child.  The assets are managed by you (the custodian), but contributions become the property of the child at his/her age of majority (usually 18 or 21 depending on your state).  Advantages over the 529 Plan are that the assets do not have to be used for college, and you can invest the funds in just about anything.  (The 529 is restricted to college funding and has limited investment options.)  This becomes a viable strategy for someone who has appreciated stock to gift to the student (529 Plans only allow cash contributions), or who is not satisfied with the investment options in the 529 plan. There are also strong disadvantages.  Any contribution becomes the property of the child when they’re old enough and they can spend it on anything they’d like.  You also can’t change the beneficiary like you can with a 529, for example if there is money leftover to put toward another child’s education.  Because the account is considered the child’s property, it is weighed more heavily in financial aid calculations.  Lastly, there is no tax deduction for contributions, and earnings are taxed as capital gains.  There is one tax benefit to putting assets in the name of the child:  currently the first $1000 of investment income is tax free, the next $1000 is taxed at the child’s rate, but anything beyond that is taxed at the parent’s rate.  UTMAs can be tricky and there is more to consider than with the 529.
Work with an advisor to determine if there is any benefit to using an UTMA vs. saving in your own account and simply paying for college when the time comes. In next week’s post, we’ll discuss how to approach the college funding plan during the high school years, the difference between grants and scholarships, and the importance of grades and activities. Of course if you have questions about your specific situation or would like answers before I finish this blog series, please email me me or post your questions or comments below.

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