By Lisa LaMarche, CFP®, CPA
College costs have been rising so fast for so many years that most parents are resigned to the fact that providing a college education for their children will be challenging.
When it comes to achieving long-term goals such as paying for college, the most valuable asset we all have is time. Having enough time allows you to approach important long-term goals like a marathon instead of a harrowing sprint. Time is what drives the power of compounding returns, which is the key to accumulating the capital to fund your goals. With each passing month or year in which you don’t save towards a goal, the cost of the goal increases, which means you must save more or earn more on your money, or a combination of both.
Even if you start saving as little as $50 a month, the additional time allows you to take advantage of compounding returns. Parents who start saving $200 a month when their child turns one year old and earn an average annual return of 6%, can accumulate $70,000 by the time he or she is ready for college. A $300 a month savings goal will increase the amount available to $105,000. (For related reading, see: College Tuition: 8 Mistakes Parents Should Avoid.)
College Savings Options
Not all college savings plans are created the same. They differ in tax treatment, flexibility and savings options, so it is important to find one that most closely matches your particular needs. Each plan type should be considered with your tax situation, savings ability and college preferences in mind. This quick overview can be used as a starting point for narrowing your selection:
529 College Savings Plans
To encourage parents to save more for college, Congress created the 529 college savings plan. As a tax qualified plan, 529 plans offer parents the opportunity to accumulate funds targeting college expenses tax free. When used for qualified college expenses (room, board, tuition, fees, books, etc.), the funds can be withdrawn tax free as well.
Offered on a state level, 529 plans are generally structured as a family of mutual funds that provide the opportunity to diversify among different types of investments. As such, investing in 529 plans can involve risks and fees that should be carefully considered and weighed against an investor’s objectives and risk profile.
Changes under the new tax law enacted last year make 529 plans even more attractive for parents seeking a quality education for their children. Effective in 2018, 529 plans can now cover qualifying expenses for private, public and religious education from kindergarten to 12 grade. However, the new law limits annual withdrawals to $10,000 per year per child when used for these expenses. (For more, see: 529 Plans: Type of Plans.)
Pre-Paid Tuition Plans
Pre-paid tuition plans are structured differently in that contributions go towards the purchase of credit directly with a college or university. The cumulative credits are then applied to tuition, and where allowed, other college related expenses. A formula is established up front to determine how many credits need to be accumulated based on a rate of inflation and minimum rate of interest. In some cases, the sponsoring institution will guarantee the tuition coverage even if the costs exceed those established in the formula.
There are some caveats and restrictions that parents need to review before committing to a pre-paid tuition plan. First, the credits can only be applied to schools within the state, or, with a private plan, only to schools participating in the program. In addition, many states are rethinking the guarantees provided in the plan, so it’s possible that your credits may come up short.
Coverdell Education Savings Account
One of the drawbacks of a 529 plan is that investors are limited to the investment options available within the plan. Coverdell Education Savings Accounts (ESAs) are a college savings alternative that offer tax-free accumulation and tax-free withdrawals for qualified expenses. They can be established like an IRA account with any financial institution with the ability to invest in whatever investment options are offered. This will enable you to fashion together your own mix of investments and create a much more diversified portfolio.
ESAs limit annual contributions to $2,000 for families with adjusted gross income less than $110,000 ($220,000 for joint filers). However, an ESA can be combined with a 529 plan or other college savings vehicles that don’t have such limitations.
Earnings inside the plan grow tax free, and the funds can be withdrawn tax free when used for qualified education expenses, including elementary and secondary expenses. Regardless of how much you accumulate inside an ESA, it won’t preclude you from qualifying for certain education tax credits, such as the lifetime learning credit. Plus, since the ESA is in the parents’ name, it doesn’t impact the child’s eligibility for financial aid.
Setting up a college savings plan doesn’t have to be complicated, and any plan can be tailored to your specific needs and budget. The most important factor to have on your side, though, when setting up a college savings plan is time. The earlier you set up a college savings plan, the more your money will work for you, long term. (For more from this author, see: 3 Key Financial Guidelines for College Graduates.)
Disclaimer: Milestone Wealth Advisors, Inc. is a Registered Investment Advisor
This article was originally published on Investopedia.