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Money Conversations: Saving for College

Financial counselors often hear a question “When is a good time to start a college savings fund for your child?” As with any type of savings, logically – the sooner the better. This is one of those financial decisions you would need to start making as soon as your baby is born. A few questions to ask here would be:

#1. Are you willing to pay for your kids’ college education when they grow up? This is more of a parenting question which really translates into ‘would you mind giving your hard-earned money to your adult children or do you believe they will need to step up and take responsibility for their own education?’

#2. Are you willing and able to set money aside for this purpose? Check your budget carefully and consider whether you have or at some point will have extra funds at your disposal to be setting aside for this goal.

#3. Are there any other financial priorities you better take care of before you commit to this endeavor? Remember the rule about the oxygen mask in the airplane: Put it on yourself before putting one on your child. Same rule applies here. A national best-selling writer and author of book “Debt Free Degree” Anthony O’Neal recommends that before you start saving for your child’s college, there are three things you need to do for yourself first: pay off your own debt, set up an emergency fund of 3 to 6 months of living expenses and start contributing to a retirement account.

If you have firmly decided to start saving for college, there are plenty of options at your disposal. It is strongly encouraged to discuss your options with a financial planner before you start, but it is a good idea to get familiar with them before you have that conversation. We will cover a few most popular options in this article, such as 529 plans, Coverdell ESAs, Roth IRAs, Minor Savings and UGMA/UTMA accounts. Sounds like Greek? Hopefully not for long.

There are two kinds of 529 plans: 529 college savings or prepaid tuition plans. The 529 savings account allows you to invest your after-tax dollars into exchange-traded securities and enjoy tax-free returns on your investment. This sounds amazing for risk-averse investors who are aware of the correlation between the risk and return of the market. The second kind, 529 prepaid tuition plan, allows you to prepay college tuition at a school of your choice in real time dollars. According to the American College Board, the cost of education rises at an average rate of 5% per year. Choosing this plan allows you to lock in today’s prices for tuition and save money on inflation. In short, 529 plans give you the benefit of higher contribution rates, tax-free growth, and flexibility to change your beneficiary. At the same time, they limit the funds for specific use only, such as tuition, room and board, and books. You would have to pay 10% penalty to use funds for other college-related expenses or to withdraw money if your kid decides not to go to school at all.

On the contrary, Coverdell Education Savings Accounts (ESAs) allow for wider range of education-related expenses while still growing tax free; however, the beneficiary changes are not as easy and the contribution is limited to $2,000 per year. That means that the most you would be able to invest until your child turns 18 is $36,000. Income limitations also apply.

In the scenario your child is able to get lots of scholarships or chooses not to go to college at all, Roth IRA (Individual Retirement Account) is the star in the sense that your money can stay invested until retirement and avoid the withdrawal penalty once you reach retirement age. However, using this account to pay for college means you will be taking away your own retirement money.

For families with a higher tax bracket, UGMA/UTMA accounts may be a good solution (a way to transfer assets to minors under Uniform Gifts to Minors Act or Uniform Transfers to Minors Act which differ by the types of assets transferred). These accounts allow to potentially enjoy lower child’s tax rate on those investments. Keep in mind that any transfers made under this law are non-revocable. That means the child now owns these assets and may use them as desired even if chooses not to pursue education at all. The same applies to any savings account opened in minor’s name. Once the minor turns 18, he or she can get access to these funds and use them as they deem necessary.

It might not be just one of these accounts, but a combination that will do the trick for you. Just like with any financial goal, the key to success here is careful consideration, staying informed and striving for diversification, or in other words, achieving good balance. However, if you find yourself in a situation where it is too late to start saving or you cannot afford to set money aside, don’t fret. There are many other smart options to pay for college which we will discuss in further articles.

JANE VAZQUEZ is a Certified Financial Counselor. She is a co-owner of a Mississippi-based company that provides services of financial consulting, bookkeeping, and tax return preparation, among others. You can reach her at www.srvcvazquez.com.

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