Today there are many college savings vehicles available to consumers. Picking the right type of college savings account can feel overwhelming. Each of them has their own sets of complex rules and often can differ from state to state. It can be tough to even know where to start, but making the correct choice while your child is still young can save you a lot of trouble down the road when it comes time to apply for financial aid and search for scholarships. The right type of college savings account can often be revealed by asking a few simple questions:
- What Is Your Risk Tolerance?
If safety is your primary concern, find out if your state offers a Section 529 Prepaid Tuition Plan. These plans let you buy tuition in today’s dollars and are guaranteed by the issuing state to give you an equivalent amount of tuition at some point in the future. It’s unlikely that these plans will outperform the stock market, but you may find comfort knowing your money is safe.
If you are looking for a higher rate of return, then a Section 529 Investment Tuition Plan may be worth checking out. These plans often provide investment options from reputable investment firms. Different states offer different options, and these plans take some research to compare. As with any investment vehicle, there is risk involved so if the market goes up, your investment will increase accordingly, but it can also decrease if the market suffers a downturn.
Series EE and Series I bonds have historically earned 3 percent to 6 percent, which lags behind the historical return of most Section 529 Prepaid Tuition Plans, but they may be less risky. Buying individual bonds in a UGMA/UTMA account might get you close to the return of prepaid tuition plan but will be subject to taxation on any interest earned above a certain amount. Using bond mutual funds in any of the other savings plans may offer an equal historical rate of return but is also subject to volatility and potential losses.
Since most states’ plans primarily cover public colleges and universities within that state, you might want to consider the Independent Section 529 Plan if you think your child might attend a private school.
- Where Do You Live?
Many states offer substantial financial incentives for using their in-state Section 529 Savings Plan. Considering that some states essentially put cash back into your pocket for using their plan, it seems wise consider this when comparing plans. Also, some states offer a deduction or credit on your state income tax return, or may actually match your contributions to the plan, up to certain limits, if you are a resident. Although you are not restricted to your own states plan, it’s a good idea to consider the tax benefits provided by your state before selecting a plan sponsored by another.
- Can You Save $2,000 per year?
If you can save more than $2,000 per year, a Section 529 Savings Plan might be your best choice. The only caps placed on contributions to Section 529 savings plans are “lifetime” totals for each child. Parents can contribute to lifetime maximums that range from the low $100,000s to over $300,000, depending on the state. Even better, these sums grow tax-deferred and may be potentially withdrawn tax-free. Best of all, Section 529 accounts allow the assets to remain under a parent or donor’s control forever. They’re even allowed to take the assets back for personal use or be transferred to another sibling if they are not all used.
If your savings goals are not in excess of $2,000 per year, then a Coverdell ESA might be good for you. A Coverdell ESA offers freedom in selecting your investments, as well as much looser standards on how the money gets spent (including tuition for grades K-12).
- What About UGMAs, UTMAs, Roth IRAs, and Trusts?
While these vehicles offer some unique planning opportunities, they will not serve most families as well as Section 529 plans or Coverdell ESAs. UGMA and UTMA custodial accounts may have negative impacts on your child’s ability to receive financial aid and require the assets to be handed over to a child no later than age 21. A Coverdell ESA or a Section 529 account offers virtually the same tax benefits as a Roth IRA, long considered one of the most tax efficient ways to prepare for retirement.
Trusts may sound impressive, but they can be expensive to set up and run. One reason to consider a trust is if your savings goals are very high and you have already exceeded the maximum allowable Section 529 Plan contribution limit.
As with many of the parts involved in creating an overall wealth and life plan, college planning is multi-faceted and complicated. Please reach out to your advisor for more information and guidance on picking the best savings account for your wealth plan.