If you have a child, you’ve probably put some thought into their future. And a big part of that future, at least for many kids, will be a college education.
When I calculate the future cost of a four-year education at an in-state public institution for a newborn, I am finding that it’ll take nearly $250,000 for them to earn a bachelor’s degree. And the cost of attendance only continues to rise!
Luckily, children have multiple ways to fund education either through part-time jobs, grants, scholarships, or student loans and they have many earning years ahead of them to afford financing education.
However, you can begin saving toward their education now to help pay for some of those future expenses and reduce the amount of debt your child will have to incur.
Below are some of the ways you can begin saving for your kid’s education.
Side Note: Before you just begin saving, make sure you have a clear picture of what you are saving for. I have an education funding conversation with my clients before they open any type of account. We explore their philosophy toward funding education for their children, what type of college they want to save for (private vs. public), and how much they want to fund (50%, 100%, certain dollar amount). Then I run an education funding analysis which calculates how much they need to save to fund their education goal.
529 Savings Plan
A 529 is an education savings plan. It allows you to invest money into an account, let it grow tax-deferred, and then withdraw it for qualified education expenses without having to pay taxes on it. It’s a pretty sweet deal.
The funds in 529 accounts can be used for any eligible institution, in any state, so there won’t be any issues if your child decides to go to school somewhere other than the state your 529 is in.
In fact, the money can even be used for foreign schools or vocational schools if college isn’t right for them.
Some states even offer incentives for contributing to their 529. Indiana taxpayers can get a state income tax credit equal to 20% of their contributions to a CollegeChoice 529 account, up to $1,000 per year.
Usually, the amount you can contribute in total to a 529 plan is pretty high (up to $450,000 per beneficiary in Indiana) but will vary by state.
If you end up with unused funds in a 529 plan, these can easily be transferred to other children or any other family member to use for qualified education expenses.
However, if the funds aren’t for qualified education expenses, withdrawals will be subject to a 10% penalty, taxed as ordinary income, and any previously claimed tax credits may be owed back.
As a result of these tax implication, it is generally recommended to avoid over-funding 529 plans.
Roth IRA
I’m often asked if it makes sense to use a Roth IRA to save for college in case a child decides not to go to college. Yes, it is possible to use a Roth IRA as a combined college and retirement savings vehicle.
When needed to pay for college expenses, you simply limit withdrawals to the contributions in order to avoid paying any income taxes on the distribution. The earnings remain in the Roth IRA to pay for retirement.
Keep in mind there are limitations to using a Roth in this manner.
First, there are income limitations to contributing to a Roth IRA. In 2019, a couple that earns more than $193,000 ($122,000 for those who file single) begin to be phased out of making contributions. Above $203,000 ($137,000 for single) and you can’t contribute at all.
Secondly, those under age 50 can only contribute $6,000 to a Roth IRA each year (2019 limits).
The main problem with this approach though is the distributions count as untaxed income on the following year’s FAFSA, reducing eligibility for need-based financial aid.
It also reduces lifetime tax-free accumulations, which are particularly valuable in retirement.
Tax-Advantaged Account
Another funding option is to save to a tax-advantaged investment account (joint, individual, or trust) since these types of accounts don’t have contribution limits.
This would be similar to saving to a Roth IRA in that you could keep the money in the account and use it for retirement if your child does not attend college.
However, you still run into the possible financial aid issues that you do with the Roth IRA and you might miss out on your state’s tax incentive.
Optimal approach
In my opinion, the optimal approach would be to fund the 529 first, especially if there is a state tax incentive available. Once the 529 funding is deemed to be nearing an appropriate level based on your goals, you can save additional college funds via a Roth IRA and/or a tax-advantaged investment account (joint, individual, or trust) to ensure maximum flexibility among your various financial goals.
It is important to note that very few people fully fund their children’s education savings accounts, such as the 529, and you shouldn’t feel pressured into believing you have to in order for your child to succeed.
Like I mentioned above, children have a lot of ways of paying for their own education and — I can say from my own experience — working during college can help keep them on track.