Summary/TLDR
There are four common ways to save for your child’s college education: 529 Savings Plans, taxable brokerage accounts, UTMAs, and student loans. 529s offer great tax benefits as long as certain rules are followed. Taxable brokerage accounts don’t have any tax advantages but are free of the strings attached to 529s. UTMAs transfer account ownership to your child at their age of majority and are often poorly suited for purposes of education savings. Student loans are a last resort and can be avoided by saving early.
Introduction
Providing your children with a bright educational future is a priority for many parents. However, navigating the maze of financial tools available for this purpose is often overwhelming. This piece aims to demystify four vehicles commonly used to finance a child’s college education. We’ll delve into each method’s strengths and drawbacks, helping you make a well-informed decision on the most suitable approach for your family’s needs.
529 Savings Plans
By far the most powerful and prevalent vehicle utilized for higher education savings is the 529 Savings Plan. Contributions made to a 529 grow tax-free as long as the withdrawn funds are used for “qualified education expenses”, as specified by the IRS. Luckily, the scope of such expenses is broad, encompassing not only tuition, but room and board, books and supplies, and numerous other academic-related costs.
A primary drawback of the 529 plan is inflexibility. If the funds aren’t used for “qualified education expenses”, the tax advantages are voided and often accompanied by significant penalties. Additionally, if your child earns scholarships, the accrued earnings remain taxable. This can sometimes render 529s less tax-efficient than some of its counterparts, explored below.
Taxable Brokerage Accounts
With a taxable brokerage account, you gain in flexibility what you lose in tax benefits. Funds in a taxable account may be utilized for any purpose, free of the strings attached to 529s.
As their name suggests, taxable accounts don’t offer any preferential tax treatment like 529s. All investment growth is taxable upon distribution. A potential silver lining can be found in the fact that this growth is commonly taxed at the favorable long term capital gains rates, an aspect which can provide for more balanced tax consequences.
UTMA Accounts
UTMA accounts are essentially taxable brokerage accounts with a twist: ownership is transferred to your child at your state’s age of majority (usually 18 or 21). If you aren’t comfortable with your child coming into a potentially large windfall, then UTMA accounts likely aren’t the right option. Furthermore, assets within the UTMA account may only be used for the benefit of your child. You cannot put funds into and out of this account willy-nilly.
Furthermore, additional care needs to be taken with UTMA accounts given their potential to trigger the “kiddie tax”, which is a special tax brackets for minors.
Student Loans
Parents who began saving late or not at all might have to resort to borrowing to finance their children’s education.
Parents can take out enough in Federal Parent PLUS loans to pay for the entire cost of attendance at a given school. Alternatively, children could apply for Federal loans in their name (which parents can then help repay) or explore private loan alternatives. Obviously, debt is often the primary thing that one is looking to avoid when planning for their child’s education, so this option should serve as a last resort.
So… Which One Should You Use?
Here’s my personal thoughts on each of the vehicles discussed above:
UTMA Accounts
These are generally a poor choice for education savings. The idea of a child taking control of a significant sum at 18 or 21 may not appeal to many parents.
Student Loans: A last resort. While they can bridge a gap, you also risk incurring debt that could burden your family or child for years.
529 Savings Plans
For most, these are the gold standard. If started early and used correctly, their tax benefits are significant. Furthermore, leftover funds may be transferred to other family members or even rerouted into a Roth IRA for your child if certain conditions are met.
Taxable Brokerage Accounts
Their flexibility is their strength. If a child earns scholarships, parents might find taxable accounts more tax-efficient than 529s. Furthermore, in an era where education is transforming before our eyes and traditional college expenses are skyrocketing, these accounts offer flexibility that aligns with modern times.
Given these considerations, a blended strategy using both a 529 and taxable brokerage account is often my preferred approach. The contributions to each account will vary based on factors like state of residence, income levels, the likelihood of scholarships, etc.
My recommendation for everyone, however, is this: start early. Neither tax breaks nor flexibility will save you from late beginnings. No matter your financial standing, you should consult a professional to understand what achieving your goal demands. Armed with this knowledge, you will be far better equipped to conquer your goals, regardless of where you stand now.
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