In the world of parenting, planning for your child’s education sits right up there with teaching them to ride a bike or making sure they eat their veggies. But with the cost of college escalating dramatically over the past 20 years, figuring out how to save for higher education can feel more daunting than convincing a toddler that broccoli is a treat. From 529 plans to custodial accounts to a standard savings account, each option has its quirks and benefits. Before discussing those, let’s talk about what you should prioritize first: saving for yourself.
Saving for yourself comes first
Before diving into the college savings pool, it’s crucial to secure your financial footing. Some might find this selfish, but I disagree. It’s practical. A strong financial foundation means you’re less likely to become a financial burden to your kids later on. If you sock away all your money into your kid’s college savings plan, you may end up having nothing saved for yourself. I remember meeting a couple years ago that had fully paid for their child’s university education using their own savings and mortgaging their house. This left their own finances in shambles at a time when they wanted to consider working less.
Prioritize having a large cash reserves savings account, paying down high-interest debts, having a savings plan for your future, and then focus on your kid’s savings. Think of it as investing in a smoother future for both you and your kids.
How much should I actually save for my kids' education?
This is a really personal question and comes down to your values. Some parents are strong believers in certain types of schools (private vs. state) and want to pay the full way; others want their kids to pay for some of their education. Whatever your preference, it’s important to know your goals before you start saving. Here is a resource showing the different costs of education over time.
Where do I actually save for my kids’ education?
Option 1: The 529 Plans
Pros:
- Tax Advantages Galore: Earnings in a 529 plan grow tax-free, and withdrawals for qualified education expenses, including tuition, books, and, more recently, computers and internet access, aren’t taxed at the federal level. Some states like NY or NJ even offer deductions or credits for contributions.
- High Contribution Limits: You can contribute hefty amounts to a 529 plan, often over $300,000 per beneficiary, making it a powerhouse for long-term savings.
- Flexibility for Family: If one child decides not to pursue college, you can switch the beneficiary to another family member without penalty. And now under the new law, if there’s any money left over you can put it into a Roth IRA for your child.
Cons:
- Limited Investment Options: 529 plans typically offer a range of investment portfolios, but you won’t have the freedom to pick individual stocks or bonds.
- Penalty for Non-Qualified Withdrawals: Funds not used for education can be hit with a 10% penalty and taxes on earnings, making it less flexible than a regular savings account.
Option 2: Custodial Accounts – Uniform Transfer to Minors Act and Uniform Gifts to Minors Act (UGMA/UTMA)
Pros:
- Flexibility in Use: Unlike 529 plans, there’s no restriction on how the money in a UGMA/UTMA custodial account can be spent, as long as it benefits the child. This means funds can go toward education, a first car, or even a down payment on a house.
- Investment Freedom: You can invest in a wider range of options, from stocks to bonds, giving savvy investors more control over the portfolio. This is unlike 529 plans where the state or institution dictate what your investment options are.
Cons:
- Control over the use of funds: Legally, the money belongs to the child once they reach the age of majority (usually 18 or 21, depending on the state). They can spend it as they see fit, which might not always align with educational goals.
- Impact on Financial Aid: Money in a custodial account is considered the child’s asset and can significantly reduce eligibility for need-based financial aid.
- No Tax Perks for Education: Unlike 529 plans, there’s no tax advantage for saving in a custodial account. Earnings are subject to capital gains tax, and there’s no tax break on withdrawals, regardless of their use.
Option 3: Saving in Your Own Account
Pros:
- Maximum Control: Saving in your own taxable account or high-yield savings account gives you complete control over the funds. You decide when, where, and how the money is spent.
- Investment Choices: Like custodial accounts, you’re not limited to specific investment options. Diversify as you see fit.
Cons:
- No Tax Perks for Education: Unlike 529 plans, there’s no tax advantage for saving in a personal account. Earnings are subject to capital gains tax, and there’s no tax break on withdrawals, regardless of their use.
- It’s All About Discipline: With easy access to the funds, it requires discipline to earmark and preserve savings for education purposes without dipping into them for other expenses.
Saving for your child’s education is a marathon, not a sprint. It requires careful planning, a bit of sacrifice, and a clear understanding of your financial landscape. Remember to secure your own financial future first. Then, choose the savings vehicle that most aligns with your family’s needs and goals. Whether it’s the tax-efficient 529 plan, the flexible custodial account, or the straightforward personal savings route, the best plan is the one that makes you feel confident you’ve done your best to prepare for your child’s future.
Jim is a financial advisor and owner of Thinking Big Financial, Inc. Thinking Big Financial is a fee-only registered investment advisor offering financial planning and investment management services. Specializing in working with the LGBTQ Community.
Please read my legal disclaimer here.