The average college student who borrows money to pay for his or her education graduates with more than $25,000 in debt. To reduce this financial burden, many parents look to saving plans in lieu of borrowing options. We rounded up some of the best payment strategies to help you navigate the ever-changing college savings landscape.
529 College Savings Plans
529 College Savings Plans are designed to encourage families to save for future college costs. There are no income, age, or annual contribution limits with 529 plans. They are widely popular because of their various tax benefits. Earnings in a 529 plan grow federal-tax free and won’t be taxed when you take the money out to pay for college. Moreover, the majority of states offer additional tax deductions or credits for 529 plan contributions.
The Catch: First, you have limited control over your portfolio because it will be managed by a state-appointed firm. You’ll also have to wait 12 months after you pick your portfolio to make any changes or transfer the money to another plan. Be sure to keep meticulous records of your spending, because you’ll have to pay taxes and penalties on any money used for non-college expenses.
529 Prepaid Tuition Plans
Prepaid Tuition Plans offer you the opportunity to prepay future tuition costs at today’s tuition rates. They offer the same tax benefits of the 529 college savings plans with an added assurance. States operating the plans guarantee that your funds will rise in value as college tuition costs inflate. In other words, a semester of college purchased today is guaranteed to still be worth a semester of college in a decade, even if tuition expenses have tripled by then.
The Catch: Prepaid Tuition plans are only available at certain public and private colleges and universities, and plans will not cover the full cost of tuition for out-of-state schools. Many states who offer prepaid plans have age and grade requirements as well. Just like 529 college savings plans, any unqualified withdrawals on non-college expenses are eligible to be taxed.
Roth IRAs are typically associated with retirement savings, but they can help fund college expenses as well. Any money that you put into the account can be withdrawn tax-free and penalty-free at any time, regardless of the purpose. Education expenses are also exempt from the 10 percent early-withdrawal penalty.
The Catch: Unlike many of the other savings plans, your contributions won’t be rewarded by additional tax credits or deduction. Also, any withdrawals to the earnings portion of the account are eligible for taxes and penalties until you reach retirement age (59 ½).
Custodial accounts allow parents to put money and assets in trust for a minor child and act as the trustee of the account until the child reaches 18 or 21, depending on the state. Custodial accounts don’t have contribution limits, and they are a great way to cover the college expenses that aren’t covered by the 529 plans.
The Catch: Once your child turns 18 or 21, the account is theirs and they can spend the money however they choose – be it on textbooks or a trip to Europe. These accounts also lack the tax benefits of other savings methods because they are taxed annually, as well as when you make a withdrawal. Custodial accounts could hurt your child’s chances for financial aid too – the funds are treated as your child’s assets and are assessed at a 20 percent rate.
There are a myriad of payment strategies for parents looking to help mitigate their child’s education expenses, including more traditional methods like student loans and private scholarships.
To explore these options and determine the savings plan that is best for you, contact our tax professionals.