You may want to help your children pay for college, but what is the best way to begin? I highly recommend using an investment account, as long as you have at least 10 years before your child starts college. Over a 10-year period, you will typically earn an average 6-8% annual return on your investments. When you let your money work for you during this time, compounding becomes your best friend.
For example, if you invest $10,000 today at an average 7% annual return and do not remove any of the money, in 10 years you could have about $20,000. If you add $500 per year to that account and keep everything else the same, you will have about $27,000 after 10 years. (You can try out Fidelity’s College Savings Calculator to run more equations).
But where should you invest?
There are a number of different types of investment accounts that can be used to save for college, so let’s dive into the differences between them. Everyone’s financial situation is unique, so it is important to find the one that is best for you. The account types I discuss in this article are:
- Uniform Gift to Minor Accounts/Uniform Transfer to Minor Account (UGMA/UTMA)
- 529 Plans
- Personal Investment Accounts
- Roth IRAs
- Uniform Gift to Minor Accounts
UTMAs and UGMAs are a great opportunity to save for college. An UTMA or UGMA is an account set up in your child’s name with a custodian on the account. The money transferred into the account is owned by the child and can be used as the custodian sees fit for whatever that child’s needs are until the child reaches the age of majority (this varies state to state, but usually is between 18 and 21). The custodian of the account can be anyone. When the child reaches the age of majority, he/she takes control of the account, and the custodian no longer has any authority over them. This can be a pro or con depending on how much you trust your child with money and if you intend for the money to be a gift to him/her. Any money in these accounts needs to be seen as a complete gift to the child that cannot be taken back.
These accounts do have tax benefits: The first $1,150 (2022) of unearned income (interest, dividends, or capital gains from investments) is tax free and the next $1,150 (2022) is taxed at the child’s rate (usually 10%). This means until the account is quite large, the taxes owed on it are minimal or nonexistent. After the $2,300 (2022) of unearned income mentioned above, the rest of the gains are taxed at the parents’ tax rate. Because the money put into this account has already been taxed, the only taxes owed will be for interest, dividends, and capital gains.
There are no penalties for taking money out of the account at any time or for any reason. Another advantage for these accounts is there is no limit to the investment choices, so with the right advisor, they will result in a larger average return overtime. Each individual is limited to the annual exclusion gift limit ($16,000 in 2022) for the amount they contribute annually to the account without incurring gift tax. UTMA/UGMA assets are also considered the property of the child and count more heavily toward financial aid calculations.
In summary, these accounts are nice because of the flexibility and freedom they offer; they do not have the best tax incentives, but they have decent ones; and the money contributed is a complete gift to the child.
- 529 Accounts
529 Accounts are college saving accounts set up within your state. There are both prepaid tuition plans and a savings plan. Prepaid tuition plans allow you to prepay tuition at a college or college system at today’s tuition rates. Not all states offer these plans and typically you need to be a resident of the state to participate. Your child also then must attend one of the colleges in the plan to use it.
More commonly, a 529 Savings Plan allows you to save for college and invest in various mutual funds and ETFs (similar to a company 401(k) plan). 529 plans can be used to pay for primary and secondary education, as well. However, some of the state incentives may not apply if they are used in this way. Different states allow for different tax deductions for contributions to these plans. It is important to look at how your state handles these plans as you are deciding if they are a good fit.
It is also important to know whether or not you need to be a resident in the hosting state to take advantage of the benefits. The money in these plans does grow tax free and taxes are never owed if the funds are used to pay for qualified education expenses. However, there is a 10% penalty and taxes are owed on the growth of the funds if they are not used for qualified education expenses.
The funds can be transferred to another relative to pay for his/her qualified education expenses without penalty if the child you set the account up for does not attend college or does not use all the money.
Another advantage is the ability to “super-fund” these accounts. That means an individual can gift up to 5 years of the annual gift exclusion amount in one year ($16,000 x 5 = $80,000) as a contribution to the account. (These numbers are as of 2022.) A couple can contribute double this amount, up to $160,000 in one year. If this amount of money is around, this is a great way to jump start these accounts. On the other hand, the investment options in these accounts are rather limited and may not perform as well as an account that can be invested in the entire market.
- Personal Investment Account
Another way some parents choose to save for college is to set up a personal investment account in their own name and then mentally designate it for their child(ren)’s education.
This allows the money to stay in the name and possession of the parents. The money can be invested in the entire market, so you’re not limited to a menu of mutual funds or ETFs, like you could be in a 529 plan. You can use it as you see fit for whatever costs you want to cover.
You will pay taxes annually at your tax rate on dividends, interest, and capital gains, but there are never any penalties for taking money out of the accounts. Because the money also remains in your (the parent’s) name, it counts less in financial aid qualifications. You do need to be disciplined about not touching this money until it is time to pay for college because there is nothing stopping you from using it for something else.
- Roth IRA
A Roth IRA is a type of individual retirement plan that you make contributions to with after-tax dollars (money you already paid income tax on). If you will be older than 59 ½ when your child goes to college and money has been in the account for at least 5 years, you can take money out of the account without having to pay tax on the earnings. If you will be younger than 59 ½ , you will have to pay tax on the earnings when the money is withdrawn.
The contribution limit for a Roth IRA is $6,000 per year until age 50, as of 2022. After age 50, you can contribute up to $7,000 per year. However, there are important income limits to keep in mind and it’s best to consult an accountant about your eligibility. If you and your spouse have a modified adjusted gross income of $214,000 per year, you can’t contribute to a Roth IRA. If you are single and have a modified adjusted gross income of $144,000 per year, you are also ineligible. (Not sure if you make too much money to contribute to a Roth IRA? Check out the IRS’ guide.) Money in a retirement account, including a Roth IRA, does not count toward financial aid calculations.
As you can see, there are many opportunities to save for college. Hopefully one will resonate with you and your financial situation. Some families use more than one option. For example, they may have UTMA accounts for each child and a 529 plan only for their oldest child that they plan to pass down to the younger ones as needed. In this circumstance, if a child does not attend college, there are others to pass it along to. As you digest this information, I recommend you reach out to a financial professional with your ideas and see what his/her recommendations are. With his/her help, you can create a plan that works for you and helps you feel confident about funding your child(ren)’s college.
About de Author
Written by Erica Mathews: Erica is a financial planner and investment advisor. She currently works for Financial Counseling Associates. She completed her course work for the CERTIFIED FINANCIAL PLANNER™ certification at the College for Financial Planning and is one year of experience away from completing her certification. She is passionate about helping families build their wealth so they can live out the calls God has places on their hearts. She lives in Colorado with her husband and four kids. They love everything outdoors including gardening, hiking, biking and simply exploring nature. If you would like to reach out to Erica her email is firstname.lastname@example.org