Saving for Education
The cost of providing an education for your child has increased significantly in the past few decades and shows no sign of slowing down. It is crucial then, that you understand to the ins and outs of saving for your child's education and create a plan to do so. Here are the most popular financial devices used to save for a child's education and a description of how each one works.
Education Savings Accounts (Coverdell Education Savings Accounts)
Education savings accounts (ESAs) are both the most general, and restrictive way of saving for education. On one hand, ESAs let you save for many types of educational expenses, including private schools and elementary education, and aren't limited to college. They have significant tax breaks both for earnings on the account and for withdrawals. On the other hand, they come with a host of potential restrictions:
- You cannot fund the ESA once your child reaches the age of 18
- You can only contribute $2,000 a year total (if the child's grandparents also create an ESA, then the accounts combined can only reach $2,000)
- If the account is not used (for instance your child ends up not going to college), the account will be distributed to your child and is not refunded back to you
- The account must be fully withdrawn by age 30.
- You must make less than a certain amount of money to qualify (roughly 100k for individuals and 200k for couples)
- Many benefits of ESAs are set to expire unless Congress reenacts them
529 Savings and Prepaid Plans
There are fundamentally two types of 529 plans, savings and prepaid. A 529 works much like a 4011 or IRA. You choose from several different investment options and make steady contributions to the account. Like an ESA, they generally avoid federal and state income taxes so long as they are used for qualified educational expenses (e.g., tuition).
The major distinction between a savings and prepaid plan is this: savings plans can be used at almost any school, whereas prepaid plans limit you to in-state schools. Here is a chart comparing some of the differences between a savings and prepaid plan:
Can be used at almost all colleges and universities
Can only be used at qualifying in-state colleges and universities
Does not secure a set tuition price
Secures a set tuition price
Is not guaranteed and is subject to market risk, the account could even lose money
Many plans are guaranteed and backed by the state
Defines "educational expenses" broadly, to include room and board, books, etc
Typically only considered tuition and mandatory fees as "educational expenses"
Typically has high contribution limits and flexible contribution amounts
Typically has lower contribution limits and rigid contribution amounts
No age limits
Most plans have age and grade limits
No residency requirements
Typically requires owner or beneficiary to be a state resident
U.S. Savings Bonds
The U.S. savings bond is typically the safest financial option, and thus the least likely option to give a high return for your money. Expect a low rate of return in the single digits, but balance that against the promise that its return is guaranteed by the U.S. government. Like the other education savings options, there are significant tax breaks associated with U.S. savings bonds, and you can redeem them tax-free when they are used to pay for college tuition and fees. It's worth noting that, starting in 2010, the tax exclusion is phased out for higher earning individuals and couples.
Other Financial Options
Though not traditionally used to fund the full amount of a child's education, there are a few other financial options worth considering:
- IRAs: IRAs typically face an early withdrawal penalty, but this penalty is waived if the withdrawal is to pay for qualified educational expenses (post-secondary).
- Lifetime Learning Credit: You can claim a tax credit of up to $2,000 on tuition and fees for yourself, your spouse and your children. This credit is phased out for higher earning individuals and couples and cannot be used with the Hope Scholarship Credit.
- Hope Scholarship Credit: In 2009, 2010 (and beyond if Congress extends it) parents can claim a tax credit of up to $2,500 for their child's tuition and fees. This credit is phased out for higher earning individuals and couples and cannot be used with the Lifetime Learning Credit.
- Custodial Accounts: Custodial accounts are simply accounts created for the benefit of your child which can be used to pay for anything for the child's benefit, not just education. These accounts are taxed, but they are taxed at your child's rate, not your own.
Tax credits, in particular, change from year to year, so be sure to investigate what tax credits might be available to you, your spouse and your child.