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College Financial Planning: How to Save for Your Kids’ School

By Team Tomorrow
Published September 10, 2021

You shouldn’t have to worry about your two-year-old’s college financial planning. They’re two. 

Unfortunately, unless we change our approach to how education is paid for, college costs will continue to grow at about twice the rate of inflation. Children born today can expect college to cost them 4x the amount it costs now. 

According to U.S. News, the average tuition and fees for the 2020-2021 school year were:

  • $11,171 for state residents at public colleges 
  • $26,809 for out-of-state residents at public colleges
  • $41,411 at private colleges

That’s only for tuition and fees. By the time your two-year-old is ready for higher education, the College Savings Plans Network estimates that the total expense four years of in-state public college (tuition, fees, textbooks, room and board, etc.) will cost $261,277. If your two-year-old decides to go to private school, that number balloons to $598,063.

And these numbers don’t include grad school. 

If you’re feeling stressed and demoralized, you’re not alone. Saving for college isn’t easy, but by starting early, you can save a lot more than you think. In this post, we’ll cover the most common, helpful strategies used for college financial planning, how each of them works, and their pros and cons:

  • 529 plans
  • Coverdell education savings accounts
  • Custodial accounts 
  • Traditional and Roth IRAs
  • Savings bonds
  • Permanent life insurance policies
  • Home equity loans

There’s a lot to cover, so let’s get started:

College Financial Planning: 529 Accounts

529 accounts are tax-advantaged savings plans meant to pay for college, K-12 tuition programs, and apprenticeship programs. These accounts are like IRAs and help your designated beneficiary cover expenses like:

  • Tuition and fees
  • Room and board
  • Education-related equipment
  • Special needs equipment 

529 plans are administered by all 50 states and Washington DC, but their rules can vary from state to state. Anyone can open one, whether you’re a parent, grandparent, or another loved one. Also, there’s no limit on how much you can contribute yearly. However, most states put a cap on the total amount you can put into them overall, usually somewhere between $235,000-$500,000.

529 plans are tax-deferred until the funds are withdrawn, and the person or people funding them are also eligible for tax benefits and dedications.  

These plans usually have a limited impact on financial aid, but that depends on whom the account owner is and what college or university the beneficiary chooses to attend. 

Savings Plans and Prepaid Tuition Plans

There are two main types of 529 accounts: savings plans and prepaid tuition plans.

529 savings plans are the traditional 529 accounts. With one of these plans, the account holder contributes money and can choose the funds they want to invest in. 

Prepaid tuition plans allow you to lock in future tuition costs at current rates, which helps hedge rising college inflation. However, prepaid tuition plans typically only cover tuition and fees, and not other educational expenses. 

Money.com states these plans are great if you’re confident your child wants to go to an in-state university or one of the 300+ private colleges that sponsor a private college 529. Otherwise, a 529 savings plan is a safer bet. 

529 Accounts: Pros and Cons
Pros Cons
Flexible plans with high contributions limits Funds must be used for education
Tax benefits: federal and some states Limited state tax benefits
Usually don’t impact financial aid too much There are fees and ownership rules

Check out our post about 529 accounts to learn more about how they work. 

Coverdell Education Savings Accounts (ESA)

Coverdell ESAs offer tax-free investment growth, and when spent on education expenses, the withdrawals are tax-free. Also, they can be used for numerous elementary and secondary school costs. 

While 529 plans have no annual contribution limits, Coverdell ESAs cannot exceed $2,000 per student per calendar year. Even if you have multiple accounts, you can only deposit up to $2,000 across all of them. 

Although there’s less that you can contribute, you can use Coverdell ESAs to cover more expenses than a 529 plan, including money for uniforms, transportation, and tutoring. 

Coverdell ESAs are more beneficial for children 18 and younger than college students. If you contribute to a Coverdell ESA after the beneficiary turns 18, these deposits will be subject to a 6% excise tax. Any money left in the account when the beneficiary turns 30, must be withdrawn within 30 days, or the earnings portion becomes subject to income tax and a 10% penalty tax. 

Coverdell ESAs: Pros and Cons
Pros Cons
Greater portfolio flexibility (stocks, bonds, mutual funds, and more) Low contribution limits 
Covers more education-related expenses Meant for K-12, not as beneficial for college
Withdrawals are completely income tax-free if they’re qualified education expenses Contributions made after the beneficiary turns 18 are taxed

Custodial Accounts

Custodial accounts are investment accounts that an adult (the custodian) opens on behalf of a minor. The custodian and other adults can contribute to the account during the child’s life. There are two main types of custodial accounts popular with adults: Uniform Gifts to Minors Acts (UGMA) and Uniform Transfers to Minors Act (UTMA).

UGMA and UTMA accounts are similar, but are governed by two separate laws and have different rules about what types of assets they can hold. UGMA accounts can hold financial assets like:

  • Individual stocks
  • Bonds
  • Mutual funds
  • Index funds
  • Insurance policies
  • Cash

UTMA covers all the above and physical assets, like real estate and jewelry. 

Custodial accounts are incredibly flexible. They don’t have income or contribution limits, or withdrawal penalties. Additionally, individuals can contribute up to $15,000 annually without incurring the federal gift tax ($30,000 if filing jointly). However, once a gift is put into a custodial account, it can’t be adjusted or reversed. The account’s holdings ultimately passed into the minor’s control once they turn 18 or 21, depending on which state they live in. 

Unlike 529 plans and Coverdell ESAs, custodial accounts aren’t tax-deferred. The IRS considers the minor the owner of the account, so the earnings in it are taxed at the child’s tax rate

The biggest setback with custodial accounts is that it impacts your child’s financial aid prospects. If they are likely to qualify for financial assistance, you may want to think twice before opening a custodial account, or at least weigh the pros and cons. 

Custodial Accounts: Pros and Cons
Pros Cons
Can invest various assets Assets can’t be taken back 
No contribution, income, or withdrawal limits Limited tax benefits
Easy to manage Hurts financial aid prospects

Traditional and Roth IRAs

You can take out money from IRAs for educational expenses without having to pay the typical 10% early withdrawal fee. If you plan to use an IRA to pay for college, Roth IRAs are your best bet. Here’s why:

When you withdraw it from a traditional IRA, you’ll still have to pay income tax on the amount. With Roth IRAs, you’ve already paid those taxes. If you’ve had a Roth IRA for less than five years and are withdrawing both the principal amount and earnings, those earnings are taxable. Make sure you’ve had a Roth IRA for at least five years to enjoy their full benefits. 

Roth IRAs are like 529 plans because of their tax-deferred advantages. While money in a Roth IRA isn’t used when determining financial aid, IRA withdrawals are. Since FAFSAs use tax information from two years before determining financial need, Roth IRA funds will impact a child’s ability to get financial assistance during their junior and senior years. 

Also, remember that the money you’re contributing for college is impacting your retirement savings later on. Jeopardizing your own financial future is one of the biggest mistakes parents make when covering college costs. 

Traditional and Roth IRAs: Pros and Cons
Pros Cons
Many adults already have these set up Using money otherwise meant for retirement; also, there’s an annual contribution limit
You don’t have to pay early withdrawal fees on education-related expenses Traditional IRAs require you to pay income tax
Tax-deferred Hurts financial aid prospects after 2 years

Savings Bonds

Savings bonds are advantageous for activities like college financial planning and buying a home

The two types of savings bonds are Series EE and Series I:

Series EE bonds have a fixed-rate and earn interest. They also guarantee a return of at least double the value if kept for 20 years. The obvious downside here is your child isn’t likely to enjoy this benefit until their sophomore or junior year—assuming the Series EE Bond is purchased when they’re a newborn. 

Series I bonds also have a fixed-rate. They are adjusted for inflation at a rate calculated twice a year. 

Savings bonds are guaranteed to accumulate money. However, they do so at a slower rate than the average university’s rising costs. 

Savings bonds: Pros and Cons
Pros Cons
Guaranteed to accumulate money Accumulates money at half the rate that college costs are increasing
Series I bonds grow with inflation Traditional IRAs require you to pay income tax
Series EE bonds will double in 20 years If purchased when a child is born, they wouldn’t use until their sophomore or junior years 

Home Equity Loans

Home equity loans are traditional loans with a fixed interest rate, repayment period, and monthly payments. Typically, the loan periods are somewhere between 5-30 years and require additional fees, like application fees, attorney fees, and appraisal costs. 

If you have astounding credit, you can usually get a home equity loan for college tuition as a better interest rate than other loans. Doing so also takes the burden off your child from taking out student loans, which tend to have higher interest rates. 

However, home equity loans require you to use your house as collateral (hence the term “home equity loan”). If you can’t make the payments, you risk losing your home. It also reverses some progress you’ve made in paying off your mortgage. While some home equity loans come with tax benefits, you don’t realize by using them to cover college costs. Home equity loans are only tax-deductible when taken out for home-related reasons. 

Home Equity Loans: Pros and Cons
Pros Cons
Low interest rates with excellent credit No tax benefits
Fixed-rate, traditional loan You’re reversing the progress you’ve made on paying off your mortgage
Longer loan terms make payments more affordable If you can’t keep up with the payments, you can lose your home

Permanent Life Insurance Policies

Permanent life insurance policies come with living benefits, like paying for college. With a permanent policy, you build cash value that accumulates throughout your lifetime. This means your beneficiaries will not only receive a death benefit upon your passing, but also use some money while still alive

Permanent life policies aren’t calculated in federal financial aid, so they won’t impact your FAFSA. Policy loans are usually income tax-free, but you should double-check just in case. 

Like with IRAs, the money you take out of a permanent life insurance policy doesn’t replenish. If your college financial planning involves withdrawing $20,000 from your policy, that’s $20,000 (plus interest) less you can pass on to your beneficiaries. 

Permanent Life Insurance Policies: Pros and Cons
Pros Cons
Income tax-free May not be tax-free in certain situations
Doesn’t impact federal financial aid Less money for a death benefit later on, unless the loan is repaid
Extremely flexible Permanent life policies are more expensive than their term life alternatives

Final Thoughts on College Financial Planning

College financial planning can be stressful. We want what’s best for our children, but providing that isn’t always easy. By starting your college financial planning early, you can have enough money to cover some or all your child’s education costs. To learn more, read some of these other posts in our saving for college series:

  • Link to How to save for college
  • Link to How much will college cost when I turn 18
  • Link to 7 money saving tips 

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