Financial Boot Camp Series: College Savings 101

As young parents, my husband and I met with a financial planner who asked about college savings. We responded that they were on their own. Fast forward to college and we couldn’t let them incur that much debt. So we helped. As I am now a financial planner, I cringe at that decision of my younger self.   

When is the best time to start saving for college? Now. No matter how old your future student is, any set-aside savings will offset what you need to fund in the future. What is the best vehicle for savings? We will look at 529 plans, Roth IRAs, and UTMA accounts. 

A 529 plan is typically state sponsored. Funds contributed to a 529 plan will grow tax free and are withdrawn tax free for qualified education expenses. Many states offer a choice between two options: prepaid tuition plans and investment savings plans. Prepaid tuition plans allow you to purchase credits now to use later at a state university. Investment savings plans give you the flexibility to invest your contributions in publicly-traded funds to use later for any eligible school you wish. K-12 education can also be paid for with an investment plan, subject to certain limits.

There are often state tax advantages to these accounts as well. There are no income limits for contributions. You can change beneficiaries to other members of your family if you do not use the funds for the intended beneficiary. You can also elect to front-load the account, or contribute five times the amount of the annual gift tax exclusion in a single year. There are specific ways 529 plans are considered for FAFSA (Free Application for Federal Student Aid) inclusion. Furthermore, each state may have different rules, so planning is key.

A Roth IRA is also a common savings vehicle. Like a 529 plan, the funds grow tax free.  Obviously, the purpose of a Roth IRA is retirement savings, but you can also withdraw for college expenses. Unlike 529 plans, there are income and contribution limits. As long as the account has been in existence for over five years, after you attain age 59.5, funds can be withdrawn tax free for any purpose. Before age 59.5, withdrawals are tax- and penalty-free if used for qualifying expenses, which includes college expenses.

Still, to avoid taxation, a Roth IRA may be a better strategy for an older account owner. Unused funds are available to fund the owner’s retirement. The account will not be considered in FAFSA calculations, but withdrawals will be considered as income to the student. There are also no state tax benefits. Still, this is a good option if you are older and have a substantial Roth IRA balance, or if you are not sure if your student will pursue higher education. More importantly, you don’t shortchange your own retirement. 

Finally, the UTMA (Uniform Transfers to Minors Act), or custodial account, is a savings or investment vehicle that you establish on behalf of a child. You can make gifts at any time, and in any amount, subject to the annual gift tax exclusion and gift tax reporting rules. As custodian, you can use the account to fund education expenses for your minor child. Once the child is an adult, depending upon state rules, the funds become their sole property. Earnings on the account are taxable in the year received, and subject to federal and state income tax. It is an irrevocable gift to the child and cannot be transferred to another beneficiary. There are no state tax breaks, but there are no restrictions on the use of the funds.

The UTMA will be considered the child’s asset for FAFSA filing. Keep in mind, if you start with an UTMA and wish to convert it to a 529 account, it will still be a named custodial account. The child is the owner and you, as the guardian, will not be able to change beneficiaries. Furthermore, if there are capital gains in the UTMA account, they will be realized upon conversion, and additional taxes will be due. 

In short, these are three opportunities to save for college. Each option has additional regulations that you should consider. Evaluate your specific situation, and with the help of your financial advisor, choose your best solution. Remember, there is no wrong way to save. 

Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice. Registration with the SEC does not imply any level of skill or training.