to obtain a quality education. Trust me on this one: What your kids really need from you is the peace of mind that you have your own retirement plan in place so they will not be asked to support you later on.
THE BEST WAY TO SAVE FOR COLLEGE: 529 PLANS
If you have the ability to save for college, the best way to save is by setting aside money in a 529 college savings plan. The two big advantages of a 529 plan are a series of valuable tax breaks and the fact that just a small percentage of assets (less than 6%) inside your 529 account will be used by college financial aid offices when evaluating your family’s request for financial aid.
529 Plan Basics
A 529 plan allows anyone, regardless of their income, to contribute money into a special savings account that works much like an individual retirement account. There is no annual limit to what you can set aside; the lifetime savings limit is typically $300,000. You choose the investments for the account, and while the money is invested in the 529 plan there is no tax bill. Withdrawals from the plan that are used to pay for “qualified” school expenses will be tax-free. Depending on the state you live in and the specific plan you choose, you may also be able to claim some of your contribution as a deduction or credit on your state income tax return.
A 529 plan is, in my opinion, a better way to save for school than an UGMA/UTMA, a Coverdell Education Savings Account, or a Roth IRA.
UGMA/UTMA
These are custodial accounts that adults set up for minor children, as permitted by the Uniform Gifts to Minors and the Uniform Transfers to Minors acts. The child is in fact the “owner” of the account. There are tax benefits to these accounts, but I do not like them for college savings for two important reasons: Once a minor child reaches the age of 18–21 (depending on your state), he or she has complete control over the assets. If your child decides to take the money and head out for a global adventure, you have no legal right to stop her. The other problem is that UGMA and UTMA assets are treated differently than 529 assets when assessing your family’s application for financial aid. Less than 6% of assets held in a 529 plan owned by a parent (for the benefit of a child) are used to compute a family’s eligibility for aid. By comparison, 20% of assets owned by your child—such as an UGMA or UTMA—are factored into the calculation. In other words, money owned by a child will reduce your eligibility for financial aid, or the level of aid your family qualifies for.
COVERDELL EDUCATION SAVINGS ACCOUNT
There is nothing inherently wrong with a Coverdell (previously known as an Education IRA) but they don’t offer any major advantages over a 529. As with a 529, money you invest in a Coverdell grows tax-deferred and withdrawals will be tax-free if used for qualified education expenses. While there is no income test for making contributions to a 529 plan, married couples with income above $220,000 (or $110,000 for single tax filers) are ineligible to contribute to a Coverdell. Moreover, the current annual maximum contribution to a Coverdell—effective through 2012—is just $2,000.
ROTH IRA
It is absolutely true that a Roth IRA can be an interesting way to pay for college costs. No matter your age, money you originally contribute to a Roth IRA can always be withdrawn without penalty or tax. And if you withdraw any of the money you have contributed before age 59½ to pay for college costs, you will not owe the typical 10% early withdrawal penalty, though you will owe income tax on the earnings. (There are special rules for Roth conversion IRAs; see this page for details.)
The problem with using a Roth IRA to pay for college costs is that it can compromise your retirement planning. A Roth IRA should not be asked to do double duty: It cannot be a college fund and a retirement fund. If that’s your strategy you and I both know what is going to happen: Because college costs
THE BEST WAY TO SAVE FOR COLLEGE: 529 PLANS
If you have the ability to save for college, the best way to save is by setting aside money in a 529 college savings plan. The two big advantages of a 529 plan are a series of valuable tax breaks and the fact that just a small percentage of assets (less than 6%) inside your 529 account will be used by college financial aid offices when evaluating your family’s request for financial aid.
529 Plan Basics
A 529 plan allows anyone, regardless of their income, to contribute money into a special savings account that works much like an individual retirement account. There is no annual limit to what you can set aside; the lifetime savings limit is typically $300,000. You choose the investments for the account, and while the money is invested in the 529 plan there is no tax bill. Withdrawals from the plan that are used to pay for “qualified” school expenses will be tax-free. Depending on the state you live in and the specific plan you choose, you may also be able to claim some of your contribution as a deduction or credit on your state income tax return.
A 529 plan is, in my opinion, a better way to save for school than an UGMA/UTMA, a Coverdell Education Savings Account, or a Roth IRA.
UGMA/UTMA
These are custodial accounts that adults set up for minor children, as permitted by the Uniform Gifts to Minors and the Uniform Transfers to Minors acts. The child is in fact the “owner” of the account. There are tax benefits to these accounts, but I do not like them for college savings for two important reasons: Once a minor child reaches the age of 18–21 (depending on your state), he or she has complete control over the assets. If your child decides to take the money and head out for a global adventure, you have no legal right to stop her. The other problem is that UGMA and UTMA assets are treated differently than 529 assets when assessing your family’s application for financial aid. Less than 6% of assets held in a 529 plan owned by a parent (for the benefit of a child) are used to compute a family’s eligibility for aid. By comparison, 20% of assets owned by your child—such as an UGMA or UTMA—are factored into the calculation. In other words, money owned by a child will reduce your eligibility for financial aid, or the level of aid your family qualifies for.
COVERDELL EDUCATION SAVINGS ACCOUNT
There is nothing inherently wrong with a Coverdell (previously known as an Education IRA) but they don’t offer any major advantages over a 529. As with a 529, money you invest in a Coverdell grows tax-deferred and withdrawals will be tax-free if used for qualified education expenses. While there is no income test for making contributions to a 529 plan, married couples with income above $220,000 (or $110,000 for single tax filers) are ineligible to contribute to a Coverdell. Moreover, the current annual maximum contribution to a Coverdell—effective through 2012—is just $2,000.
ROTH IRA
It is absolutely true that a Roth IRA can be an interesting way to pay for college costs. No matter your age, money you originally contribute to a Roth IRA can always be withdrawn without penalty or tax. And if you withdraw any of the money you have contributed before age 59½ to pay for college costs, you will not owe the typical 10% early withdrawal penalty, though you will owe income tax on the earnings. (There are special rules for Roth conversion IRAs; see this page for details.)
The problem with using a Roth IRA to pay for college costs is that it can compromise your retirement planning. A Roth IRA should not be asked to do double duty: It cannot be a college fund and a retirement fund. If that’s your strategy you and I both know what is going to happen: Because college costs
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