It's never too late to start saving for our child's college education, but the earlier you start, the better. You'll thank yourself for it later when every dollar you put aside now reduces student loan debt after graduation.
You probably can set aside a specific amount every pay period to build a college fund - but it takes some good planning and self-control for college financial planning. And with a good plan, your money can grow.
College experts say planning for college expenses in advance helps reduce stress – especially when it comes to external factors, such as hikes in student loan interest rates or tuition. When you plan earlier you have less stress and more money to put into education and your child's future.
Wealth advisors recommend younger clients start saving for college early – even if it's a small amount. You can save for your child's college costs tax-free. Many families put aside money from their paychecks for their child’s future college costs. College experts recommend parents start saving early and regularly through automatic deductions every month.
Whether or not you’ve already started saving, you should know that there are special savings accounts that can benefit you: 529 college savings plans and Coverdell Education Savings Accounts (ESA).
Let’s look at these in more detail:
529 Savings Plan
One of the most effective ways to save for college is with a 529 savings plan.
A 529 college plan is a way for families to save and invest for college with tax-deferred earnings and tax-free distributions on education expenses.
Opening a 529 account and saving before sending a student to college is part of developing a college budget.
And with the help of a good financial advisor, selecting the investment funds in the 529 account can help your money grow.
Benefits of a 529 plan:
There are many different 529 plans, and each plan features different investment options. So it's a good idea to research which plan fits the needs of your family.
This is where working with an experienced financial advisor can help, both in choosing the right type of plan, but also in making changes over the years to maximize the opportunity for growth.
The earnings from your 529 savings plan aren’t subject to federal tax, neither while they’re in the account, or when you withdraw them either, as long as the funds are used for qualified education expenses.
In addition, depending on your state’s tax regulations, you may be able to deduct some or all of your contributions.
Further, 529 accounts provide flexibility. You can transfer the account to another family member — as long as the new beneficiary is related to the original beneficiary.
So, if your first child gets a scholarship and doesn't need all of the funds in his/her account, you can change the beneficiary to another child to be used for his education goals.
Or you can use the money for yourself to get that next degree. You can even choose to hold on to it for a future grandchild.
Usually the account owner is the parent or grandparent, and the beneficiary is a minor. The account owner maintains and controls the account, making all the decisions about taking withdrawals and changing beneficiaries, for instance, as well as selecting investments.
So you, as the owner, have the final say about how and when the money will be used.
Here are some final things to know about a 529 savings plan:
Coverdell Education Savings Account (ESA)
A Coverdell Education Savings Accounts (ESA) is a trust or custodial account designed to help families pay for education. Just like a 529 savings plan, a Coverdell ESA offers tax-free earnings growth and tax-free withdrawals when the funds are spent on qualified expenses.
When it comes to the FAFSA (Free Application for Federal Student Aid), both the 529 and ESA are treated the same. Neither account will hurt your children’s chances of getting federal financial aid, including grants.
With both plans, the money grows tax-free and isn’t taxed when you take it out—as long as it is used for qualified expenses. If you use it for a non qualified expense you’ll get hit with federal taxes and a 10% penalty, no matter which program you chose. The government is serious about using this money for educational purposes!
Then what is the difference? The biggest difference between an ESA and a 529 savings plan has to do with the way you invest the money, in other words, the investment options. With an ESA, you can choose almost any kind of option—stocks, bonds, mutual funds. You can't do that with a 529 plan. You can also change the investments to different places any time you want (also not an option with a 529).
Here are some more ESA differences:
While financial planners say personal savings should be the primary source for college funding, those savings can become challenged if a family loses its primary breadwinner. With some life insurance plans, the death benefit protection can be used to pay tuition costs.
With life insurance, parents purchase a cash value policy that can pay for a child's college education in the event that the family's primary breadwinner dies prematurely. These funds can then be accessed as a tax-free loan or withdrawal when it comes time to pay for your child's college tuition costs.
One thing to think about when considering life insurance that differ from both 529’s and ESA’s is FAFSA. The cash value of a life insurance policy is not reported as an asset on the Free Application for Federal Student Aid (FAFSA).
However, distributions from a cash-value life insurance policy must be reported as taxable income or untaxed income to the beneficiary on the subsequent year's FAFSA. And since a FAFSA must be filed every year to qualify for financial aid, this does make a difference.
Investing in Life Insurance to pay for college
Here’s how permanent life insurance works as a college savings tactic: For every dollar you pay in premiums, a portion goes towards the death benefit and another portion is diverted to a separate cash-value account.
From an investment perspective, whole life insurance is generally the safest version. The issuer credits your account by a guaranteed amount, although it may pay more if the investments perform well. Most policyholders can expect a return of anywhere from 3% to 6% after the first several years.
Other types of coverage, such as variable life insurance, give policyholders a degree of control over their investment. In this case, you select the sub-accounts – essentially mutual funds – that you want to be attached to your policy, and your account’s annual return is pegged to the performance of these underlying investments. The potential reward is greater, but there’s a risk that your balance could fall in a given year if the market takes a plunge.
When it’s time for your son or daughter to start college, you can take out a loan against your cash balance. The insurer will reduce your death benefit if you don’t pay back the loan, but that’s not necessarily a drawback for those who intended the policy primarily as a college savings plan.
In most cases, the principal portions of these loans are tax-free.
When contrasted with a 529 plan, life insurance has a couple of benefits. One is flexibility. Suppose your child decides against going to college. Any earnings in your 529 account, but not your contributions, will be subject to ordinary income tax rates.
There are some plans that allow the beneficiary, who is usually in a lower tax bracket, to withdraw the funds. But it’s still a significant tax hit that life insurance owners don’t have to face.
But there are less attractive features of permanent life insurance. There are upfront and recurring fees that can make stock and bond fund fees look like a steal. For example, 50% or more of your first-year premiums will typically pay the commission. As a result, you’re starting in a pretty big hole.
It can take 10 years or more for your cash value to surpass what you paid in premiums. So unless you buy a policy before your kids are in kindergarten, it’s hard to make a case for life insurance as a way to build up your assets.
On top of that, heavy annual expenses continue to weigh down your earnings. Most permanent life policies charge upwards of 2% per year in administrative and investment costs.
The simple answer is no. That’s because over the long haul, you’d get more return by investing that money instead of locking in a tuition rate.
Not only that, but with most prepaid tuition plans, the state will only refund the principal (not any interest you’ve earned) if your child decides not to go to college.
And you can’t pass along that money to another sibling.
Here’s the bottom line: You want to stay in the driver’s seat with your money, whether it’s in an ESA, 529 plan or your own retirement fund.
Call us at Leeward Wealth for a free consult, and let’s look at your specific situation and best options.