For many, the concern is not about our children getting accepted to college, it’s how we are going to pay for it. Long before your child is selecting a major, their college savings plan should be in place and growing.
When do you start? What’s the right investment strategy? How should it change over time? These are just a few of the topics we will cover in this week’s Inside Look at Building Towards Wealth.
1. Start Early – A Long Time Horizon Builds Value
The earlier you start, the more your savings could potentially grow. A savings account could be a good option if your child is starting college in the next couple of years. If your child is more than a couple of years away from entering college, then an investment account is also a good option.
2. Don’t Just Save – 529 Plans Provide Tax and Investment Advantages
529 plans are tax-advantaged savings plans. 529 plans are not just for college – tax-free withdrawals may also include up to $10,000 per year in tuition expenses for K-12 schools. However, state tax treatment of K-12 withdrawals varies.
Although contributions are not deductible at the federal level, earnings grow tax-free and there is no federal tax on withdrawals to pay for qualified college expenses. Depending on your state, you may be able to deduct contributions from your state taxes.
If you live in the State of IL, like my wife and I do, you receive a deduction from your state taxes up to the first $20,000 invested per year. That’s a $990 tax savings at today’s current 4.95 % tax rate.
However, if you use 529 money for K-12 expenses and an Illinois income tax deduction was previously claimed for contributions to the account all or part of that deduction may be added back to income for Illinois income tax purposes.
Think carefully before using 529 money for K-12 expenses in IL and states with similar provisions.
All 529 plans have a plan manager, usually a financial services firm, that manages the portfolio of investments. You will be able to create a portfolio from an offering of mutual funds and ETFs, and tailor it to your time horizon and investment preferences.
Both you and your spouse (and anyone else that wants to – it’s not limited to parents) can contribute up to $16,000 per year each (in 2022) and still fall under the gift tax exemption limit.
The gift tax exemption rules allow you to bunch up to five years of gift tax exemptions, so you can contribute up to $80,000 at once.
The key to saving is to do it consistently. Figure out your budget, plan the amount you can invest, and have it automatically deducted from each paycheck.
3. Get Your Child Involved: Custodial Accounts Create Commitment
Getting your child involved in the process by setting up a savings or investment account that they can contribute to is a great way to keep them focused on college and teach them some basic financial skills.
The Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act (UGMA/UTMA) allow you to create a custodial account in a minor child’s name. This can be done at a bank or with a brokerage firm.
The accounts can be used to deposit gifts of cash that the child receives – for instance, birthday or holiday checks from family and friends, and for the child to save his/her own earnings.
4. Shift the Allocation Through the Journey
Similar to shifting your retirement portfolio allocation to be more conservative as you get closer to retirement, your child’s 529 plan allocation should be monitored and reallocated as they progress through high school and the time horizon gets shorter. Your financial advisor can help you make decisions to preserve what you have built up and provide for continuing growth.
5. Got a Late Start or Have a Generous Benefactor?
If you are over the gift tax exclusion and the 529 plan isn’t enough, paying tuition directly to the college or university is of course always an option. This applies to anyone – not just parents, so if grandparents, partners, friends, or others want to help out, they can make payments directly, without penalty.
Don’t Limit Your Options
The second most important factor in affording college? Encourage creative thinking, in yourself and your child, instead of a focus on one school or one specialization.
Many children are taking their core classes at a less expensive community or local college before finishing their degree at a more expensive college. This does limit the “college experience” for the child, but it can help fit within a budget.
The Takeaway
When it comes to paying for college, there’s a lot to think about. There are many variables to consider, but the most important thing is recognizing the need for planning and taking action ahead of time. Being proactive is much less stressful than being reactive, especially when it comes to money and savings. By laying out your options, weighing the pros and cons, and taking your own financial situation into account, you can begin to build a flexible plan that meets your needs.
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