4 Smart Ways To Plan For Your Child's Education

Steve Pietila
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4 Smart Ways To Plan For Your Child's Education

When parents think about their children going to college, the first thing they see is dollar signs.

And with good reason!

Forbes reports that for a student pursuing an undergraduate degree between 1980 and 2020, the average price of tuition, fees, and room and board increased 169%. While the COVID-19 pandemic has slowed this growth, there’s no denying that college tuition has become extremely expensive.

Luckily, there are options to help parents save for their children’s college education. We’ll dive into 4 solutions that could work for you and your family.

A 529 Plan

A 529 plan is a state-sponsored tax-advantaged investment vehicle for education expenses. Your contributions to the account are after-tax, grow tax-free, and distributions for qualified education expenses remain tax-free.

Your child can use the funds to help pay for tuition, room and board, books, supplies, and other qualified expenses.

There are two types of 529 plans: the prepaid tuition plan and the education savings plan. Both types offer the same tax advantages but differ in their investment selections and methods.

Let’s take a closer look at each plan.

Prepaid Tuition Plan

With a prepaid tuition plan, you pay tuition rates at a particular school now that your child can use in the future. Participating in-state public colleges typically offer this plan.

Whoever manages the plan will pool your contributions and other investors into one general fund. These funds are then invested in the hope that they will grow. While growth isn’t guaranteed (just like any other investment), the hope is that you will receive an annual return that is at least equal to the rate of tuition inflation.

Education Savings Plan

This plan is the more popular/common of the two. In a nutshell, an education savings plan allows you to save for college within an individual investment account, like a 401k.

You can invest the money you contribute in the plan’s investment options, usually a selection of mutual funds and ETFs, with the hope that it grows to help your child pay for school. But with any investment, your return is not guaranteed.

Other 529 Characteristics To Be Aware Of

Most 529 plans are open to residents of any state. This means you can shop around for the plan that offers the best features, like low investment fees, broader investment selections, and more.

However, keep in mind that if you enroll in another state’s plan, you may miss out on certain tax benefits that are reserved for in-state residents.

529 Plans also have no annual contribution limits! But, be mindful that the IRS considers contributions to a 529 as “completed gifts.” In 2022, you can give up to $16,000 per donor.

Plus, you have the option to “super-fund” 529s by front-loading five years’ worth of contributions at once. If you’re following the gift tax rule, that's up to $80,000 this year. Keep in mind that this strategy has pros and cons. Our team at First Dakota can sit down with you to discuss your options to see if this strategy might work for you.

Most 529s also have lifetime gift limits, but they're often sky-high (consider between approximately $260,000 and $520,000 depending on the state).

Roth IRA

While not specifically designed for college savings, you can use Roth IRAs to save for a college education. You fund these accounts with after-tax dollars, earnings grow tax-free, and some distributions may remain tax-free—it all depends on how you use it.

If you withdraw funds for qualifying education expenses, you will have to pay income taxes on the distribution, but you’ll avoid the 10% early withdrawal penalty.

For those familiar with this type of account, you know that there are contribution limits. In 2022, those who meet the requirements could contribute up to $6,000 between both a Roth and traditional IRA. Except for those 50 or older who can contribute an additional “catch-up” contribution of $1,000.

Pros of Using a Roth IRA to Pay for College

  • Can help reduce reliance on student loans
  • Can be invested for long-term, tax-free growth
  • No penalty for education-related withdrawals

Cons of Using a Roth IRA to Pay for College

  • Could cut into retirement savings: if you invest too much to cover education expenses, you may not have enough left to meet your retirement savings goals.
  • Roth IRAs (like any other investment) don’t guarantee returns
  • It might impact financial aid: Distributions count as income on the FAFSA, which could jeopardize eligibility for loans, grants, and other assistance.
  • Income and contribution limits: You cannot contribute if you exceed the income threshold. Also, as mentioned earlier, Roth IRAs are subject to annual contribution limits depending on your age.

Custodial Account

With a custodial account, a parent or guardian contributes to the account on behalf of a minor.

There are two types of custodial accounts:

  • The Uniform Gifts to Minors Act (UGMA)
  • The Uniform Transfers to Minors Act (UTMA)

You can contribute equity, fixed income, real estate, commodities, and other assets. Like 529 plans, custodial accounts don’t have contribution limits, but many people stay within the annual gift tax exclusion to avoid reporting the gift to the IRS.

Custodial accounts do come with tax benefits, primarily that a portion of unearned income is taxed at the child’s tax rate. For 2022, the first $1,150 isn’t taxed, the next $1,150 is taxed at the child’s tax rate, and anything over $2,300 is taxed at the parent’s tax rate.

Perhaps the most significant thing to consider with this type of account is that the child has full access to the funds at 18, or the “age of majority” in your state.

This is undoubtedly a huge responsibility!

Legally, the account's beneficiary doesn’t have to use the funds to pay for college. Instead, they might decide to travel the world, buy a home, etc. Essentially, there are no rules or limits on how they can spend the money. Be sure to bear this responsibility in mind if you wish to go this route.

Brokerage Account

Brokerage accounts are widely considered the “most flexible.” How does it earn that title? Through this account, you can invest in stocks, bonds, mutual funds, exchange-traded funds, and other types of investments.

It’s important to note that brokerage accounts don’t receive any tax-free or tax-deferred benefits, like some of the others we’ve discussed.

Similar to other account types, you don’t have to use the funds from this account for educational purposes. You can also use this fund to help your child ongoing—rent after graduation, wedding, down payment on a house, etc.

Create a Comprehensive College Plan

It's often best to use various vehicles to fund your education goals. We can help you understand what your goals are (fully funding college, just paying tuition, enrolling in private elementary/hs, etc.) and build a plan that helps you get there.

Please contact us anytime. We’d love to work with you!

Disclaimer:

First Dakota Wealth & Trust is the fiduciary investment department of First Dakota National Bank with trustee powers to serve clients during their lifetime, during incapacity, and after death. We help clients develop a financial roadmap to help simplify their financial future.

Please note that neither First Dakota National Bank nor First Dakota Wealth & Trust Department, or its employees provides tax or legal advice. This is intended for informational purposes and is not intended to constitute legal or tax advice. Please consult your attorney and/or tax professional for advice related to your specific situation.