If you are like 45% of American families saving for college, you might be doing it wrong. A recent stat suggesting that almost a majority of American families saving for college are using a standard savings account is enough to make a trained financial advisor scratch his head in dismay. You may have your reasons for selecting an account with a return (on average) of 0.5% annually, but you should be aware of some alternatives. Especially if your child is young and your focus is on saving for their future.
If you know your child is going to college and you are setting aside that money to pay a bulk of the tuition, then a 529 may be your best option. It’s most tangible benefit is tax free gains. That means you’re not paying taxes on the money earned in the account. There is no annual contribution limit and friends and family can even contribute once a beneficiary has been named. The account holder (you, the parent) maintain control of the account, thus it’s not the beneficiary’s when they turn 18.
Since nothing regarding investing and the tax code is simple, there are a few drawbacks to a 529. First and most importantly, the money must be used for higher education (tuition, room and board, supplies). Taking money out of the plan for something other than higher education will incur a hefty 10% penalty and additional taxes. Your investment choices are limited to those available within the plan. Finally, while there aren’t annual contribution limits, there are total contribution limits which are set by the program, most of which are in excess of $250,000.
If you are not sure if your child will go to college (or think they will get a full scholarship), then an UTMA may be your best option. An UTMA provides parents a way to save and invest while maintaining control of the account until the beneficiary reaches majority age (varies by state). There are no limitations on how you spend the money (private high school, music lessons, etc.) and you have complete control of the investment options and choices. There is also no limit on total investment.
There is a cost to the flexibility in spending that an UTMA provides. In one word, taxes. In an UTMA you will pay taxes on your gains and that can significantly impact how much money you have left to spend. Also, you lose control of the account when the beneficiary turns 18. Just imagine, you spent 18 years saving for Junior’s college fund. He gains control of the account, drops out of school and buys a Ferrari!! You’ve raised him better, but you never know!
Don’t let the complexities of laws and regulations keep you from getting started. Don’t be in the 18% of American families that plan to raid their retirement to pay for college. Assess your situation and choose the option that best meets your needs and goals. In the end, the laws and standards regarding UTMA’s and 529’s are always subject to change. You can dig into the details here to learn more about each option and how it best meets your needs
By Brian Evans, CMO