Last week, we reviewed a book on children, money and values. One topic the book covered was saving for kids’ needs, which typically included either education or providing them a nest egg post-college. The book didn’t provide details on what vehicles were available to parents or grandparents for saving for education, so we’ll do that this week.
Saving for college is the most common concern for parents, and 529 plans were established specifically for college savings. They function similarly to Roth IRAs in that growth on the funds in the account isn’t taxed and there is no tax on withdrawals as long as the funds are used for qualified educational expenses.
529 plans are flexible and allow owners to change beneficiaries, which can come in handy if the original beneficiary doesn’t need to use all the funds in the account. In addition, many states offer tax deductions for 529 contributions, although contributions aren’t deductible at a federal level1. Despite these advantages, some parents forego the 529 because the funds must be used for qualified educational expenses, or any withdrawal will be subject to a penalty. We’ll cover a few options that offer more flexibility below.
Another option in saving for education is the Coverdell Educational Savings Account. Unlike 529 plans, the Coverdell isn’t just limited to covering college expenses – it can be used to cover primary and secondary educational expenses as well. Like 529 plans, the beneficiary can be changed, but unlike 529 plans, annual contributions are limited to $2,000 per beneficiary per year and the funds must be used by the time the beneficiary turns 30. Lastly, income limits preclude high-income earners from contributing to a Coverdell.
Another more flexible educational savings option that works for some parents is a parent-owned Roth IRA. The Roth offers similar tax advantages to the 529, but there are no restrictions on the use of funds when they are withdrawn. For this strategy to make sense, a few things have to be true:
- The parents need to be eligible to contribute to a Roth.
- The financial plan confirms that Roth savings aren’t needed to meet the parents’ retirement or other financial goals.
- When the funds are needed for college, the parent who owns the Roth will be over the age of 59 1/2 . This will avoid the possibility of tax or penalties on the funds withdrawn from the Roth.
One final common option for saving for education is a standard taxable account titled in one or both of the parents’ names. The advantage of this approach is that it offers the most flexibility – the funds can be used for any purpose with no potential penalty. The downside is that growth and income on the account will be taxed.
A taxable account in the name of the child is also taxable, and thanks to the kiddie tax, earnings can be taxed at the parents’ tax rate. Additionally, the money is legally the child’s, which means she could spend it on whatever she wanted once she reaches the age of majority. Finally, when it comes to determining financial aid, assets in the name of the student reduce potential aid by more than assets in the name of a parent.
There is no single ideal vehicle for saving for education. Control, flexibility, and taxation are all considerations, and the account choice will ultimately depend upon the unique circumstances of the parent and child.
- If you file a joint return, Georgia allows a deduction of up to $4,000 per beneficiary per year for contributions to the Georgia 529 plan. ↩
Micah Porter, CFP, CFA® is a financial advisor based just outside Atlanta in Decatur. You can contact him here.