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Exploring Tax-efficient Strategies For College Savings And Education Planning
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College seems a long way away when you bring your new baby home from the hospital, but the distant nature of higher education shouldn’t push college savings strategies too far down your priority list. The good news is that there are several methods that can help you start saving now and potentially save your child (and you) from student loan debt. More good news: We help you choose the right approach for your family by explaining how the following options work:
The College Board reports that average annual tuition and fees can be just under $11,000 per year for in-state residents at public universities and just under $39,000 per year at private colleges.
Multiply that by four, five or six years and you’re talking about a big number. But taking that number and dividing it by your monthly savings goal can help you create a solid plan of action.
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Anticipating that college costs will continue to rise, let’s say you want to cover $50,000 of annual college costs for four years once your baby turns 18. Saving around $500 a month and earning 5% along the way will do the trick. With this calculator you can do the math yourself and play out any number of scenarios.
Once you have a goal in mind, embarking on a diligent college savings plan early can mean success later based on small contributions over a long period of time. There are a variety of college savings accounts to help you achieve this goal.
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So-called 529 plans are the most popular education-specific savings plan and are growing. They come in two types: as an investment savings account or a prepaid tuition plan.
A 529 savings account allows you to invest in mutual funds or exchange-traded funds that carry the same risk/return profiles as other stock- and bond-based investment accounts. Meanwhile, prepaid tuition plans allow you to effectively “lock in” tuition costs and avoid the impact of ever-increasing fees. Let’s look at both options.
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A 529 savings account allows you to set aside after-tax contributions that grow tax-free, similar to a Roth IRA, but with much higher contribution limits. Proceeds can be used for qualified educational expenses such as tuition, room and board, and books. This does not include general living expenses and buying a car for college. Such ineligible expenses will be taxed and subject to a 10% penalty.
Although investment brokers often list state-specific 529 plans, it’s a good idea to check your own state’s plan first. Many states offer tax breaks or credits to their residents, and some even provide matching funds as an additional incentive. Savings may be used for qualified educational expenses at any college, not just those located in the resident’s home state.
Additionally, 529 plans purchased directly from a public college savings website can mean lower fees—and you can often choose from prefabricated age-based investment plans that adjust the investment mix based on the child’s age.
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College tuition usually increases each year. One way to “lock in” your tuition costs is to participate in a 529 prepaid tuition plan. You can avoid future tuition increases by prepaying all or part of the cost of attending a particular university or, in some cases, a group of institutions that participate in a particular plan. For example, you can pay for eight terms in today’s dollars; This will save you eight periods in the future, even if the costs are higher then.
Sounds too good to be true, right? In fact, some education systems have realized what a bargain this is and have discontinued their prepaid plans. Some plans continue to operate but are closed to new students. Increasing restrictions are being placed on other prepaid tuition programs, and concerns have even been raised about the future financial viability of these programs.
While 529 plans are the most popular way to save, especially for education expenses, there are other options, each with their own pros and cons.
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Although they provide little growth compared to traditional stock investments, these accounts offer flexibility, but this can also be a disadvantage. Tapping the bill for non-university expenses in hopes of replenishing the funds later can deplete your college fund.
Using a tax-advantaged Roth IRA as a combination retirement account and education savings vehicle offers a number of benefits and some flexibility. You have maximum growth potential because your after-tax contributions grow tax-free. You also have the opportunity to invest in a virtually unlimited number of stocks, bonds, mutual funds, and exchange-traded funds of your choice, with or without the help of an investment advisor.
Roth withdrawals for qualified education expenses are allowed without penalty, but they will generally be included as income in determining financial aid eligibility.
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Coverdell Education Savings Accounts, or ESAs, are somewhat similar to a 529 with training wheels. Yes, qualified withdrawals are tax-free, and you can purchase a wide variety of investments like a Roth IRA. However, contributions are limited to $2,000 per year and are valid only until the beneficiary turns 18. There are also income limits.
Although their growth potential is potentially small, ESAs may offer more flexibility than 529 plans. Eligible expenses on Coverdell accounts may include educational expenses throughout your child’s life, from K-12 to graduate school.
For very conservative savers, tiered CDs or savings bonds may be an option, at least for part of your savings goal. This can also offer some cash flow flexibility because the portfolio will not suddenly mature at a future date.
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This is how college savings worked before 529s and ESAs existed. Trust accounts structured as UTMAs or UGMAs are funds that are transferred to a child’s account and invested on the child’s behalf until they reach the “trust termination age,” as defined in their state, which is usually between 18 and 21 years of age. Once beneficiaries reach adulthood, they can do whatever they want with the income: Pay for college or buy a sports car. Because the property is controlled by the student, the value of the account will likely affect financial aid eligibility.
While 529 plans have gained popularity as a tax-efficient and highly flexible way to save for college, the right answer for you may be a combination of different accounts. Maybe a 529 and a Roth IRA. Or ESA and UTMA. It all depends on your long-term goals, the number of potential users in your future, and your specific income and tax situation.
Starting early gives you even more options. And saving for college can be a family affair: Grandparents are often happy to contribute to a college fund using their annual gift tax exclusion.
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While your goal may be to avoid burdening your baby and potential future co-worker with student loan debt, no one said they couldn’t act on their own initiative for the next 22 years, right?
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