Latest posts by Kumiko Ehrmantraut (see all)
- 6 Steps All First-Time Home Buyers Should Take - September 23, 2020
Saving for your child's future can be an overwhelming task. Before you start making decisions, I want to make some suggestions first. Make sure you are fully funding your retirement account. Taking care of yourself and your retirement is important. There are always options to save for your child's education, but a successful retirement nest egg requires a lot of time which is an opportunity cost that can never be made up. Since the world will never stop for you to pay for your child's future nor will your financial needs stop, you need to prioritize your finances. Make sure you have paid off debt, especially high interest debt. You will never be fully ready to save if you have portions of your budget being used for interest payments. Make sure you have an emergency fund in place. Being able to cover unexpected costs now will save you from paying more later. Once you have taken care of your retirement, paid off high interest debt and have accumulated an emergency savings, then the question becomes how to save for your child's future. Whether you are wanting to save for a rainy day or educational expenses, there are a ton of options out there.
529 College Savings Plans
These type of accounts were named after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996. If you choose a 529 account, you will be able to set money aside for you child's education and it will grow tax-free. You will not be federally taxed as long as the withdrawals are used for higher education. The great thing about a 529 is that any family member can contribute to the account as a gift. Any family can contribute to a 529 regardless of income, and start with as little as $25.
Answers to common questions regarding 529 College Savings Plans:
What colleges are eligible?
You can see which colleges are considered eligible institutions at the following link – Is your institution 529 eligible?
Does a 529 Plan effect financial aid?
Yes, but it depends on who the account owner is. If the 529 is owned by a dependent student of one of their parents, the assets are considered parental assets on the FASFA. The Expected Family Contribution (EFC) is calculated using a maximum of 5.64% of parental assets. The higher the EFC, the lower the financial aide.
What happens if my child doesn't go to school and never uses the money?
If you the parent are the owner, you can always change beneficiaries. As long as the new beneficiary of the 529 is a family member, the money can be used for qualified education expenses without incurring income taxes or penalties. You can always take a cash distribution, but be AWARE of the consequences. You will have to pay both taxes and a 10% penalty on the earnings if you use the 529 for something other than qualified education expenses. 529 assets can only be used for secondary education.
**Note**
If your child gets a full scholarship to college, the penalty for taking the cash is waived
Open a college 529 savings account in under 5 minutes with CollegeBacker.
Coverdell education savings accounts (ESA)
Coverdells have similar characteristics to an IRA, but are used for educational purposes instead of retirement. You can only make a yearly contribution of $2,000 and the money will grow tax free. You contribution dollars and the interest in the account are not taxed when you make a distribution as long as you use it for education purposes. The great thing about Coverdell accounts is that the assets can be used for elementary and secondary school costs (K-12) as well.
Answers to common questions regarding Coverdell ESA accounts:
What happens if my child never uses the Coverdell?
If money is unused by the time your child reaches 30, the unused portion can be rolled over to another eligible family member who is under the age of 30. If the money is not used or rolled over, the ESA will be distributed and taxable to the child.
Who can contribute?
Family members, friends and even the child for whom the account is being established can make contributions to the Coverdell ESA. Since 2002, small organizations and corporations have even been permitted to make contributions. Keep in mind that there are income limits for the person making the contributions, so you want to make sure to check this out before making a decision.
UTMA (Uniform Transfers To Minors Act)
These types of accounts are in a completely different world than the two previous savings options. In an UTMA, a donor makes a contribution into the account and the money instantly becomes property of the child. The UTMA account is established under the minor's social security number but a custodian will manage the account until the minor reaches a certain age (usually 18 or 21). Any withdrawals from the account must be used for the benefit of the child.
Answers to common questions regarding UTMA accounts:
What if I don't want my child to have full control over the account when he reaches the required age?
Keep in mind that in an UTMA, the assets are the property of the minor, not the parent or guardian. Legally, they have full access to the account once they hit the required age. However, the custodian on the account is the only one who can initiate the distribution. This will give you some control, but if you are not fully confident about your child handling the money you have set aside for them, I would suggest looking into other options. These accounts are basically used to allow the minor to own the assets without filling out costly trust paperwork or seeing an attorney.
How does an UTMA impact financial aid?
UTMA money is considered assets of the student so it has a very high impact on financial aid eligibility. You can read more about the impact on financial aid here: Impact on Financial Aid Eligibility.
What is the tax treatment for withdrawals?
Any distributions from an UTMA must be reported on the child's tax return and is taxed at the child's rate.
I have only listed 3 ways to save for your child's future, but there are many more options out there. I highly recommend seeing a financial adviser to find which option is best for you. I have worked in the finance industry for almost 5 years, and after talking with my financial adviser I determined the UTMA was the best solution for my family. Personally, the option to financially support my son for things other than college expenses made the most sense. Whatever option you may choose, or not choose, saving for your child's future is more important than ever.
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