College savings options: a run-down
Recently I wrote about 529 plans, and whether they’re still a good choice for college savings. Generally I think they are a valuable savings tool for most people (though that doesn’t mean they have to be used to the exclusion of everything else, nor should you fund a 529 plan - or college savings at all - to the detriment of your own retirement savings). But let’s look at all the other ways to fund your kids’ higher educational aspirations:
Cash savings and taxable brokerage accounts
The most flexible: the amount you save or invest isn’t tied to income, there are no deadlines, and the investment possibilities are virtually infinite, and you can withdraw money to spend on anything with no restrictions
Drawbacks: earnings (either interest in a bank account or capital gains when investments are sold) are taxable; if owned by the parent, it will reduce financial aid eligibility by up to 5.64%; if owned by the student, the reduction can be up to 20%
Roth IRAs
This has become a popular funding strategy in recent years, since contributions can be withdrawn anytime for any reason, and while there would normally be a 10% early withdrawal penalty on earnings, that is waived for qualified higher education expenses. Withdrawals of contributions are tax-free and here again, investment options are basically unlimited. The Roth itself is not counted as an asset for FAFSA purposes, since it’s a qualified retirement account (the same goes for Traditional IRAs, and 401k/403b plan assets, but they don’t have the same ease of access as the Roth and shouldn’t really be considered for college funding purposes)
Drawbacks: you can’t replace the money once it’s removed; contribution limits are pretty low (only $6,000 per person this year if you’re under 50) and income limits apply, so even doing the contribution can be tricky. And while withdrawals of distributions are tax-free, withdrawal of earnings is taxable, and crucially, withdrawals of either contributions or earnings are considered income on the FAFSA, so this money is better used for later years when it will have less of a financial aid impact
529
This is a valuable option because it offers attractive tax incentives: while no federal tax break is available for contributions, some states do offer a deduction for residents; further, the growth of the investments, and distributions for qualified educational expenses - which are pretty broadly defined - are also tax-free. The owner - typically the parent - can change the beneficiary if needed and can even use the money themselves for their own future educational needs. You can access any state’s plan, and are not limited to schools in that state; indeed, even some schools outside the US are eligible.
Drawbacks: it will have a small impact on financial aid eligibility; there will be penalties on the earnings (and possible state income-tax recapture o the contributions) if the money is used for a non-qualified purpose. If the 529 is owned by someone besides the parents, like a grandparent or aunt or uncle, the withdrawal is considered income to the beneficiary and could have significant financial aid implications - in this situation, those assets would ideally be used for the later college years, as with the Roth IRA assets.
Coverdell ESA
These are less popular than they used to be, because the contribution limits are even lower ($2,000 per year per beneficiary) and income limits apply, but without the workaround of the backdoor strategy for a Roth IRA.
UGMA/UTMA
There’s no limit on the amount you can save in these accounts; and it can be spent on anything as long as it’s for the benefit of the minor, even if it’s not education-related.
Drawbacks: earnings (either interest in a bank account or capital gains when investments are sold) are subject to the kiddie tax, which is quite high after the first $2100; the child will have full ownership once they reach legal age, so accumulating a significant amount here might be inadvisable. And these are counted as a student asset for FAFSA purposes, so they would have a disproportionate financial aid impact
Life Insurance
Funding a whole or universal life insurance policy, and then using it to pay for college, is a strategy that parents consider because the cash value of the policy is excluded from parents’ assets on the FAFSA. The cash value can be borrowed, tax-free, to pay expenses (and those expenses don’t need to qualify); plus you can fund any amount you like with no restrictions.
However: it takes quite a long time for enough cash value to accumulate to meet tuition obligations (at least 10 years from the initiation of the policy); the policy holder must continue to pay the premiums during the life of the cash value loan, as well as interest on the loan. As an alternative to the loan, you can surrender the policy and simply use the cash value, but there will likely be tax on the gain, and the proceeds then get included in the rest of the parental assets. There will likely be a guaranteed minimum return on the cash value while it accumulates, but also likely a maximum return, forgoing any appreciation above the maximum.
As you can see above, there are pros and cons to all of the above strategies and ideas. For most people, a mix of savings types will work best, and the amount will be determined by the family’s needs and circumstances.