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Thursday thoughts: College savings 101

Posted January 27, 2011

This week we have a guest post by Dan Griffin of SavvyDollar.org about some of the best ways you can pay for upcoming college expenses. Thanks for the valuable information Dan! Feel free to share your thoughts and experiences on saving for college below. 

College Savings 101

For a lot of parents in our generation, putting aside enough money to pay (or mostly pay) for your child's college expenses is a top priority. In this blog post, I hope to shed some light on some of the best ways that you as a parent or grandparent can save most effectively through tax advantaged opportunities. But before we get into that, I'd like to take just a minute and encourage you to be selfish. Yes, you heard me right. What I mean is I'd like to encourage you to put funding your retirement ahead of funding your children's college tuition. Why? The key reason is that you can't borrow to fund your retirement. Can you imagine going to a bank and saying, “Hi, I'd like to see someone about getting a loan to help me pay my bills in retirement.” That's unlikely to be fruitful, but teens have plenty of borrowing options for college – and frequently even at subsidized rates. If you prioritize their college savings over your retirement savings, you potentially could wind up in a position where Junior has his entire college experience paid for, but you have very little (or nothing) set aside for your own retirement. That's not good.

That being said, lets get down to the nitty gritty. What are the best ways to save for your kids' (or grandkids' college.)

529 Plans
Probably the most well known option is the 529 plan. A 529 plan allows you to make contributions to an account with a named beneficiary. While there is not a federal tax deduction when you make the contribution, all of the future earnings will be tax free if used for qualified college expenses (tuition, books, room and board).

529 plans are administered by states – and you can literally pick any state's plan that you want – but there may be a tax benefit if you choose your home state. Lucky for us, NC has an excellent 529 offering. It has very low fees (which is arguably the only true indicator of long term performance) and a good smattering of Vanguard fund choices. To sweeten the deal a little more, NC will give you a state tax deduction on 529 contributions up to $5,000 per year (for married filing jointly). Since the NC state tax rate is around 7%, you're saving $350 in taxes right out of the gate.

When it comes time for Junior to go to college, you can withdraw the money and not owe any tax as long as the money is used for “qualified” expenses. The only issue – and some people would love to have this problem – is that you theoretically could over fund the account and have more than is needed to pay education expenses. In that scenario, you could either designate a new beneficiary or choose to pay a withdrawal penalty.

Pros: tax free earnings, state tax deduction, no income restrictions, easy to change beneficiary
Cons: only valid for college (not private elementary or high schools), penalty if money is not used for qualified college expense.
Where to find more: IRS publication 970, College Foundation of NC

Coverdell Educational Savings Accounts

Coverdell Educational Savings Accounts (named after their original sponsor Senator Paul Coverdell) are another savings option that have traditionally offered more flexibility than 529s. As recently as a month ago, these were scheduled to scale back allowed contributions to $500 per year, however at the last minute they were renewed by Congress until at least 2012.

 

The basic idea of ESAs is similar to 529s. You make after-tax contributions to an account on behalf of your student. When the money has grown, you won’t owe tax on the earnings if you use it for qualified expenses.

There are two key differences between 529s and ESAs. On one hand, we have limits applied here that do not apply to 529s. You are currently limited to $2,000 of contributions per year per student, and income caps make ESAs unavailable for those in higher income brackets. On the other hand, the key advantage of ESAs is that they are more flexible than 529s – offering the option to pay for elementary and secondary expenses (as well as college) and also offer a much more liberal definition of qualified educational expenses.

 

Roth IRAs
You've probably heard of Roth IRAs – but usually in a conversation involving retirement savings. So what are they doing here in an article about college savings? One of the lesser known traits of the Roth IRA is that it actually can be effectively used to pay for college expenses – and without any penalty if you only withdraw the principal (not the earnings). That “principal-only option” offers great flexibility for parents who may or may not need to withdraw that money for their own retirement.

Let's say in our first scenario that mom and dad contribute the max to their Roth every year with plans to withdraw the principal one day for Junior's education. Junior ends up getting a scholarship and none (or very little) of mom and dads money is needed. Unlike the 529, which would then have to either be used for someone else's college expense (or otherwise cashed out with a rather stiff penalty) the Roth IRA can be withdrawn tax free as soon as mom and dad are age 59 ½ (with no penalty). That's a huge benefit!

In the second scenario, mom and dad are saving for their retirement in their Roth IRA with hopes that some will be left for education after their retirement needs are met. Through a series of better-than-expected events, mom and dad end up with plenty of money for retirement from other sources. They decide the Roth money can instead be used for Juniors college expenses. In this scenario, they could withdraw their principal (the money they have contributed) without paying any taxes or penalties. They could also withdraw the earnings portion if they wanted and avoid the 10% penalty, but would still owe Uncle Sam tax on the earnings. So the best route here is to try to contain the withdrawal to the principal only if the parents are younger than 59 ½.

Roth IRA Pros (as it relates to education): flexibility to be used for retirement or education
Cons: Earnings portion is taxed if withdrawn while parents are younger than 59 ½, income caps on who can contribute

I realize that this is a confusing topic – and there is more to it than what I've written in this short article. For example, some assets are counted “against” the student on their FAFSA student loan application while some assets are not. If you are planning your retirement and/or educational savings, I recommend you setup some time with an hourly (fee-only, non-commissioned) NAPFA-associated Certified Financial Planner. You can find one at napfa.org.

Post contributed by Dan Griffin
Dan is the founder of Savvydollar.org a North Carolina focused savings forum. He has an MBA from UNC-Chapel Hill and while not currently working in the financial industry recently passed the national Certified Financial Planner exam. He can be emailed at dan@savvydollar.org.

 


 

6 Comments

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  • Faye Prosser - Smart Shopper Jan 28, 2011

    I agree, RCC. I hope to have many books paid for through the Upromise account by the time the girls go to college.

  • Oxymoron02 Jan 27, 2011

    Upromise.

    I joined in 2001. While I could definitely bank a lot more Upromise coin for my kids' college if I paid attention to what was and what wasn't contributing products, I'm really not about to spend more money for brand X over brand Y because of a few pennies into my kids' college fund. Still, I accidentally buy the "right" products from time to time, and I make a habit of checking the Upromise site before ordering things online to see if I can score a percentage back on something I was going to buy anyway.

    My logic, when I joined 10 years ago, was if at the end of it all I've earned $50 towards my kids' educations, that's $50 more than I would otherwise have had. I've earned more than that, btw. :)

  • leeandkaren2 Jan 27, 2011

    Just make sure you put saving for YOUR retirement first. Children can always work to help their college bills and apply for scholarships, but the way things are going social security is not going to be what it is today and your children are not going to pay for your living expenses. I had to pay for my college and children will survive without it supplied for them.

  • dan17 Jan 27, 2011

    Great links Faye. I'd also like to recommend a forum at http://bogleheads.org/forum. They are some of the most knowledgeable and willing to help folks you will find. (I read and post there just about every day.)

  • Faye Prosser - Smart Shopper Jan 27, 2011

    Great question Erika! Here is a worksheet that allows you to enter savings info to help determine how much you will need to save:

    http://www.smartmoney.com/personal-finance/college-planning/how-much-should-you-save-9648/

    Here's another one from Bankrate.com:

    http://www.bankrate.com/calculators/college-planning/save-for-college-calculator.aspx

    I also highly recommend savingforcollege.com - read everything on the site!

    http://www.savingforcollege.com/

    And I also concur with Dan's info about funding retirement first before college. Definitely read up on it before using all your savings to pay for college for the kids.

    Hope that helps!

  • Erika in CH Jan 27, 2011

    Here's what I'm confused about -- I have a soon-to-be 4 year-old and a 5 month-old. How MUCH should we be saving for college at this point? I just randomly chose $100/month for each in a 529 Vanguard fund. Any ideas for direction/guidance? Thanks for bringing this up Faye!