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The most important thing to remember when planning for college is time is your greatest ally. The sooner you invest, the more time your money has to compound and grow. There are several investment plans designed to help parents save for future education needs. Even if you can only afford to set aside a small amount on a regular basis, it’s crucial to start saving as early as possible.
Uniform Gifts to Minors Act (UGMA)/Uniform Transfer to Minors Act (UTMA)
The UGMA/UTMA is a custodial account placed in your child’s name and Social Security number, with an adult named as custodian. For many years, saving in a UGMA/UTMA was often recommended to take advantage of the investment earnings being taxed at the child’s tax rate. However, there are some drawbacks in terms of ownership and qualifying for financial aid.
For one thing, money held in a child’s name legally belongs to the child when s/he reaches adulthood. So, if junior decides that college just isn’t his cup of tea, you can’t prevent him from spending those college account dollars on whatever he wants. Also, when being assessed for financial aid, the assets held in the child’s name are weighted more heavily – typically, about 35% of the “child’s assets” are considered available for college expenses, versus only about 5% of the assets held in the parent’s names. This might decrease your chances of receiving financial aid.
Coverdell Education Savings Account (ESA)
A Coverdell Education Savings Account (ESA) is a special account designed to help pay for your child’s education. You set up the ESA and choose how to invest the money, typically on behalf of the child beneficiary.
When you invest in an ESA, you don’t have to pay taxes on investment income or capital gains, which means your money has a chance to compound faster.
Even better, withdrawals are free from federal taxes so long as you use the money for qualified education expenses, such as tuition, books, supplies, uniforms, room and board, computer equipment, and internet service.
Tax-free withdrawals apply not only to college expenses, but also to elementary and secondary education expenses—whether the school is public or private, secular, or religious.
The Roth IRA is an alternative investment strategy. Certain guidelines must be met before the money can be withdrawn for educational purposes, so consult your financial or tax professional for your specific situation.
Section 529 Education Savings Plans
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 savings plans are an important strategy for college savers. There are no income or age restrictions, and contribution limits are very high. The plan is not held in the child’s name, which usually means it will have less of an impact on eligibility for financial aid. 529 plans also offer the ability to leave the money in the account for later use, change the beneficiary, or withdraw the money (subject to restrictions and/or penalties on investment gains). Earnings in these state-sponsored college savings programs are tax-deferred until the money is withdrawn for higher education expenses.
Investments in 529 plans involve risks to principal and may involve additional fees such as enrollment charges and annual maintenance fees. 529 plans offer no guarantees. Depending on your state of residence and the state of residence of the beneficiary, the plan may or may not be eligible for state tax benefits. There are exceptions to the gift tax and estate tax exemptions; please contact a qualified tax, legal or financial advisor for more information prior to investing.